By Larry Swedroe
Sun Tzu is an honorific title bestowed upon S?n W?. Tzu, who lived from 544 to 496 BCE, authored The Art of War, an immensely influential ancient Chinese book on military strategy. The book, composed of thirteen chapters, each devoted to one aspect of military warfare, has long been considered one of the definitive works on military strategies. It has also had a huge influence on business tactics. Investors can also benefit from its wisdom. They can particular benefit from the insight provided by one its most often cited phrases: “Every battle is won before it is ever fought.”
On July 19, 2007, the S&P 500 Index closed at 1553. By August 15, it had fallen to 1407, a drop of almost 10 percent in less than a month. The drop was fueled by a flight-to-quality, or what might be called a flight-to-liquidity. Headlines from the financial media reported huge losses in hedge funds as investors fled all risky assets, the kind of assets hedge funds often buy.
The media (and not just the financial media) also commented about how this was an unprecedented event. The following statement is a good example. It was made by Matthew Rothman, global head of quantitative equity strategies for Lehman Holdings Inc. and a University of Chicago Ph.D. After three days of huge losses for equities all around the globe Rothman stated: “Wednesday is the type of day people will remember in quant-land for a very long time. Events that models only predicted would happen once in 10,000 years happened every day for three days.”(Wall Street Journal, “One ‘Quant’ Sees Shakeout For the Ages—’10,000 Years,’ August 11-12, 2007.)
Lehman’s models (as well as the models of many other hedge funds) may have made such a forecast, but all that proved was that the models were wrong. These events have occurred in the past, and they have done so with a fair amount of frequency. In fact, we had a very similar crisis in the summer of 1998, just ten years earlier.
The hedge fund Long-Term Capital Management [LTCM] was founded in 1994 by John Meriwether (former vice-chairman and head of bond trading at Salomon Brothers). Myron Scholes and Robert Merton who shared the 1997 Nobel Memorial Prize in Economics sat on its board. LTCM had early successes producing annualized returns of over 40 percent in its first years. Then, in 1998, it lost $4.6 billion in less than four months and became the most popular example of the risk that exists in the hedge fund industry. In early 2000, the fund folded. LTCM, failed because its models told them the same thing that Rothman’s model had told him. As Spanish philosopher Santayana warned: “Those that cannot remember the past are doomed to repeat it.”
The Historical Evidence
Professor Eugene Fama (the thesis advisor to LTCM’s Myron Scholes at the University of Chicago) studied the historical distribution of stock returns. Here is what Fama found: “If the population of price changes is strictly normal, on the average for any stock…an observation that is more than five standard deviations from the mean should be observed about once every 7,000 years. In fact such observations seem to occur about once every three or four years.” (Roger Lowenstein, When Genius Failed, Random House (1st edition, September 2000), p.71.) That is a long way from once every 10,000 years.