Investor Profile | From earning $1 billion to downfall of a Nobel laureate
Long-term Capital, a hedge fund, had an annual return of up to 40% in its early days, but unfortunately went bankrupt due to a black swan event.
Robert Merton, known as the "father of options," is a Nobel laureate in economics in 1997 and a member of the National Academy of Sciences in the United States. He is a finance professor at Harvard Business School, the highest level of professorship at Harvard University. He pioneered the field of "financial engineering" and has made enormous wealth of over $1 billion in a short period of time.
Started trading at the age of 11
Merton was born in 1944 in a small town of about 8,000 people in New York, USA. It is said that this small town has produced 6 Nobel Prize winners, which had a great influence on Merton.
His father was a titan in the field of sociology, Robert K. Merton, the proposer of the famous "Matthew effect." When Merton was a child, his father taught him baseball, poker, magic, and stocks, and provided him with various books. Therefore, at the age of 11, the intelligent Merton bought his first stock - General Motors - and made a profit from it. At the age of 15, he even modified his first car. At that time, his dream was to become a famous automotive engineer.
Known as the "Newton of Modern Financial Theory"
After entering the mathematics department of the California Institute of Technology, he spent several hours in a local securities company almost every day, trading and following the market. During that period, Merton changed his dream from becoming an engineer to becoming an economist. Merton later transferred to MIT to study economics and became a disciple of the famous Paul Samuelson. This laid the foundation for the vigorous development of the derivatives market in the next three to four decades.
Samuelson was the first American to win the Nobel Prize in Economics in 1970 for his significant contributions in applying mathematical analysis to the field of economics. During Kennedy's presidency, he assisted in formulating the famous tax policy - the "Kennedy tax cut plan." His textbook "Economics" has long been regarded as a classic by thousands of students.
His mentor Samuelson called his beloved disciple the "Newton of modern financial theory." Later, Merton organized the relevant papers and wrote an additional chapter in 1987, which became the book "Continuous-Time Finance." The American "Financial Magazine" praised this book, calling it a watershed in finance. Today, this book has become a classic textbook that must be read by American finance doctoral students.
Founder of the "Option Pricing Model"
One of Merton's greatest contributions is the option pricing theory. In the early 1970s, Merton, along with economist Myron Scholes and mathematician Fisher Black, jointly developed a complex formula for option pricing, known as the Black-Scholes-Merton pricing model (BSM model). Before that, although derivative finance had a long history, most of the research methods were more like religious beliefs rather than rigorous dialectical logic. It is difficult to find effective verification methods. The theory of option pricing has become an important sign of the transformation of economic methodology, transitioning from philosophical speculation and historical description to quantitative description and model verification.
With this academic achievement, Merton and Scholes shared the Nobel Prize in Economics in 1997. This research was immediately used by banks, traders, investors, and other financial practitioners. Prior to this, many useful financial products could not be applied because no one understood how to price costs and risks. Now, Merton's research has become the foundation of a trillion-dollar industry, widely applied in the pricing of various risk assets and financial derivatives, and laid the foundation for the flourishing field of financial engineering today.
Stan Jonas, a financial derivatives expert at Societe Generale, even said, "Everything that most people in the financial industry do is just a footnote to the work Robert Merton did in the 1970s."
Merton's research achievements in option pricing theory and financial engineering have greatly promoted the prosperity of the global financial derivatives market. Merton himself also benefited from his academic achievements. In 1993, Merton and nine others formed a company called Long-Term Capital Management (LTCM), which applied the theory created by Black, Merton, and Scholes twenty years ago in practice. Within three years of its establishment, the company achieved an annual return rate of up to 40% and became the most profitable fund company on Wall Street at that time. It is said that before the company collapsed, Merton alone shared profits of over 1 billion US dollars.
In 1997, after Merton was awarded the Nobel Prize in Economics, he was once called the "most profitable Nobel laureate."
The Cost of Intelligence
LTCM's mathematical model, based on historical data, often ignored events with very low probabilities during the statistical process of the data, thus burying hidden dangers. Once these low-probability events occurred, the investment system would have unpredictable consequences.
The so-called Black-Scholes-Merton formula is still based on the normal distribution, so the risk investment strategy of "Long-Term Capital" still starts with "linear" and "continuous" asset price models. Specifically, the core strategy of this hedge fund is "convergence trading."
This strategy does not care whether the price of a particular stock or bond rises or falls, but bets on the price of related stocks or bonds converging to the "normal state." "Long-Term Capital" placed a bet on the convergence of the prices of 30-year Treasury bonds and 29-year Treasury bonds in the United States (shorting the former and buying the latter), thinking that it would be a sure win regardless of price fluctuations.
Unexpectedly, the financial crises in Asia and Russia caused panicked investors to flock to what seemed to be safer 30-year Treasury bonds, resulting in the divergence of prices between 30-year Treasury bonds and 29-year Treasury bonds, rather than convergence. Several other "convergence trades" ended in divergence as well.
Some say their biggest mistake was trusting their models and strategies too much, but models can never quantify situations where money and emotions become close to madness. Long-Term Capital once said in a roadshow, "Risk is a function of volatility, and this can be fully quantified." "That makes sense. After all, in April 1998, at the peak of their performance, the initial investment of $1 in the fund turned into $2.85, a remarkable return of 185% in just 50 months.
It is important to emphasize again that they were engaged in hedge fund activities, so it is not fair to simply compare them with one-sided gambling. However, as summarized by Taleb, the author of "The Black Swan," "They believed too much in their models and completely disregarded the possibility of being wrong." Is this the price of being clever?
Some say it was just bad luck for them. After all, not everyone can easily encounter the Russian debt default, and Russia was once one of the two superpowers on Earth. If the market follows a normal distribution, then Long-Term Capital Management experienced events that were beyond 8 standard deviations. What does that mean? Our universe has a history of 13.7 billion years, and if there were daily trades since the birth of the universe, such events should not have occurred even once.
Others say that when a tree grows too tall, it attracts the wind, and they became the target. Indeed, during their most difficult days, market liquidity disappeared, and no one was willing to trade with them. The entire market was against them, waiting for the day when they would collapse so they could take advantage of the situation. They were once considered top hunters, but in the end, they were hunted down by even more ruthless hunters.