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Herd on the Street

With a new-found reputation for financial expertise, I thought it appropriate to offer my distilled wisdom to those innocents looking to invest. There are three laws, paralleling the laws of thermodynamics:

1. You can't win.
2. You can't break even.
3. You can't get out of the game.

This would seem to wrap things up, for those without analytical minds. More careful consideration now leads me to propose a zeroth law, also ala thermodynamics:

0. You can't assign a meaningful numerical value to risk.

Since value of an investment is measured as assets minus liabilities, and risk certainly affects liability, this has implications for total value. (I've stated earlier that the largest risks are never made explicit on balance sheets.)

From a theoretical viewpoint, this is all well and good. Does it have practical applications?

Below is an example based on my latest reading When Genius Failed by Roger Lowenstein. This is the epic story of the hedge fund Long-Term Capital Management. The partners in this fund included top traders from Salomon Brothers and professors of economics. Two were Nobel Prize winners. Value-at-risk (VAR) was an important theoretical advance of theirs. Off-balance-sheet numbers were a practical aspect of the fund.

Here is a graph of the value of an investment in this fund over time.
View attachment 2997

From this we can deduce a number of things. My favorite inference is that "long-term" means about four years.

Most people I know were kept out of this fund by the requirement for an initial investment well over $1 million. I'll admit there are some details I don't understand, like how a firm with capitalization of $100 billion could end up with 100 to one leverage on this. One suspects lending requirements are different at that level.

My title? That is due to a line stolen from a rather old financial commentary concerning risk which has once again become topical. This market is neither a bull market nor a bear market, it is chicken.


Hi anciendaze, it is possible to beat entropy in the short term in a local system, its just not possible to win in the wider system or forever.

Life itself is an example of beating entropy in the short term. Life increases entropy, but in the process it decreases entropy within the body (until death anyway).

Similarly investments can go against the system for the short term. They can also be very profitable if you offload to someone else at a great profit before the investment crashes.

It is wrong in my admittedly conservative view to think of the stock market as gambling or guaranteed profit. You are buying a share in a business, and how it turns out depends on how the business functions. If I had money I would be investing in businesses that I think have a good long term future. This requires research and risk.

You are right however that risk cannot be reliably quantified. There is risk in quantifying risk - its a spiral of uncertainty. Nobody can predict the future, particularly catastrophic events.

Hi Alex,

I confess to having a down day when I wrote that, for reasons unrelated to the subject.

The subject itself is discouraging for anyone who either has money to invest or hopes to make money, (not to mention all those whose jobs depend on the outcome of events in high finance.) The people in the LTCM partnership had all the right skills and experience, from the perspective of most financial experts. They certainly had access to sources of funding beyond any I could tap. In Wall Street terms, the fund "blew up" even as it crashed.

The question on my mind was how could anyone, even privileged investors outside the charmed circle of managing partners, know what was going on? Employees in the building, but outside the glass-walled conference room where negotiations were taking place were in the dark. All they could do is watch the markets plummet on Bloomberg.

As astute an investor as Warren Buffet made an error in an offer to buy their assets. He wrote a contract to buy Long-Term Capital Management, when he really wanted the assets held by Long-Term Capital Portfolio, a separate partnership. He was being advised in his bid by Jon Corzine, later CEO of Goldman-Sachs, who was probably the closest outsider to the group. Who actually understood the structure of this business?

From the outside, how is that story different from the Madoff scandal?
1) Madoff lasted longer.
2) Madoff lost less money.
3) Madoff confessed the whole thing was a Ponzi scheme.
4) Madoff went to prison.

Except for some disputes with the IRS over taxes, nothing in this operation came close to incurring criminal penalties. In defending himself from charges of deliberate tax evasion, Myron Scholes, Nobel Prize winner and principle author of a textbook on taxes and business strategy, stated he was not an expert on taxes. If this is so, who is?

Other aspects are reminiscent of the Enron scandal. This limited partnership controlling huge amounts of money was set up under the laws of the Cayman Islands. Their investments were distributed over thousands of individual "positions" which scarcely anyone understood. It took years to unwind these, and liquidate the partnership in an orderly manner.

My point is this, if you can't distinguish a reputable investment firm from a Ponzi scheme without inside information, what prevents even larger disasters? As we have learned, nothing does. Is it any wonder current markets are dominated by apocephalic chickens?
Howdy Anciendaze. Thanks for the CFS finance blog. Not familiar with the particular LTCM you are referring to, but sure is an ugly chart!

On the topic of unsupervized/unregulated markets. Saw a really great documentary worth watching.


It's about Brooksley Born, a underacheiver who got shuffled into an little government agency called the CFTC (commodity futures trading commission). While head of the commission, Mrs. Born tried to regulate the futures and ran into a stone wall by Robert Rubin, Larry Summers, and Alan Greenspan.

The tight-knit trio created a consensus by drawing in one more person and convinced congress to allow the market to go unregulated.(overriding Born's very well founded concerns) Hence quashing any and all efforts to regulate multi-hundred trillion dollar derivatives market (another black box).Needless to say, the whole thing blew up in a few years!

worth watching. I promise.
markmc20001;bt5748 said:
...It's about Brooksley Born, a underacheiver who got shuffled into an little government agency called the CFTC (commodity futures trading commission). While head of the commission, Mrs. Born tried to regulate the futures and ran into a stone wall by Robert Rubin, Larry Summers, and Alan Greenspan.

The tight-knit trio created a consensus by drawing in one more person and convinced congress to allow the market to go unregulated.(overriding Born's very well founded concerns) Hence quashing any and all efforts to regulate multi-hundred trillion dollar derivatives market (another black box). Needless to say, the whole thing blew up in a few years!

worth watching. I promise.
Long-Term Capital Management was not a publicly traded company, though it did do some trades in equities, (which turned out to be a weak point of the bond traders involved.) This is why it was not regulated by the SEC, and probably why you never heard of it. It was also regulated by the CFTC, as much as it was regulated by anything in the U.S. government.

Its favorite trading strategies all revolved around betting on spreads, which required going short and long on very similar bonds. Hence, it was heavily involved in futures markets.

A trivial example is the bet that spreads between 'in-the-run' and 'out-of-run' T-bills will narrow as new T-bills age. To make significant money at this you need big leverage, which means you have to borrow heavily, because the changes in value are tiny. Each trade would appear to tie up significant capital. (T-bills are denominated in $100,000. Small investors need not apply. Going long on a bond requires you buy the bond. Legal shorts also require that you own the bond you will sell in the future.) The solution is yet another curious Wall Street practice called "repo financing".

To make a long story short, two applications of "repo financing", with the T-bills used for short-term collateralized loans leaves you with essentially the same capital you began with. There will be four interest streams to juggle, two from the bonds and two for the loans, but when the options fall due you will have the bonds as required -- provided you don't 'blow up' in between. It has the appearance of a perpetual motion machine.

High finance is a small world.

Dramatis Personae: Robert Rubin spent 26 years with Goldman-Sachs, rising to co-chairman. Lawrence Summers was closely associated with M.I.T.'s economics department, where the Nobel Laureates described above taught. Alan Greenspan was, of course, the economic oracle and chairman of the Board of Governors of the Federal Reserve System, who memorably said of this position, "You soon learn to mumble with great incoherence." He excelled. When he spoke clearly, the Japanese stock market fell several percent in one day.

Other familiar faces popped up in this reading. James Cayne was the CEO of Bear Stearns who refused to contribute to the bailout of LTCM on the grounds that his company was sufficiently exposed by clearing the trades for LTCM. (This despite the $500 million of LTCM capital they held.) When Bear Stearns blew up in 2008, Treasury Secretary Henry Paulson refused to use government money to bail it out. He also recommended an acquisition price of $2/ share (down from $160 the previous year, later brought up to $10.) Paulson was a long time Goldman-Sachs partner, and later the CEO who succeeded Corzine after the LTCM blow up.

While the primary banks in the bailout of LTCM each contributed $300 million, Lehman Brothers and some French banks balked. Lehman and BNP Paribas put in only $100 million. Societe Generale put up $125 million. Lehman Brothers blew up later in 2008, after Bear Stearns. Societe Generale and BNP Paribas remain in business, but SG just had its credit rating downgraded. BNP Paribas is "under review" by rating agencies. Major bankers remember who their friends were in time of need.
Hi anciendaze, I don't think insider information would help much either unless you had information from high up the corporate ladder. As risk increases I suspect that transparency declines and spin becomes dominant. Many within LTCM may not have been fully aware of the issue, but I think a climate of unease probably would have been noticed.

Leveraging investments also amplifies risk - in a climate of high uncertainty over risk this could be very dangerous.

I am not an expert on financial issues, most of my knowledge comes from being a book-keeper in an accountancy office plus my training in corporate analysis (not financial analysis, more general than that). My comments are just opinion.

so if you have any savings, bottom line, what do you do with it? get a place, put it in savings, under the mattress.....?
Hi xrayspex, this is a time to buy shares in my view, but only in businesses that have a strong future, especially if they are underpriced. Look for investments that always do OK even in depressions and recessions - basic food items for example are always in demand. I would be wary of investing in companies that predominantly make expensive highly discretionary items or services - these are great in good times, not so great in uncertainty.

However, I am not a financial adviser. You can do worse than stick money in a secure bank on a high interest deposit. In Australia the banks are fairly solid, but this is less sure in other parts of the world.

By sheer coincidence today's news has yet another illustration of my point. For those with short memories, I'll mention that UBS, Union Bank of Switzerland, was hit hard by the LTCM scandal. They got into it through a warrant offered by LTCM which rival Swiss Bank firmly rejected as an unreasonable demand. After UBS discovered it was losing money in buckets, they fired the person responsible, and were forced to merge with Swiss Bank, which gained a controlling interest, though still under the UBS name.

UBS went through more traumatic exposure in 2008. When some of its tax strategies were disallowed by the IRS it was forced to reveal account information, and paid a huge fine. If top executives are to be believed, they did not know or did not understand the implications of what their traders were doing.

The disconnect between what goes on inside the inner circle and daily operation of a firm works both ways. If those in charge don't know, or can't control operations, you really have to wonder what investors outside a firm are doing, if they are not simply shooting craps.

The possibility that public information will not reveal exposure via derivatives or swaps means that businesses with any kind of asset, including hard assets like real estate, may be encumbered by such contracts in ways that make balance sheets completely deceptive. Unless this systemic crisis of confidence is addressed, markets will remain highly sensitive to rumors, as they seek to answer that pertinent question by xrayspex.
haha thanks for info you guys

reminds me of "healthcare", I was just thinking how the left hand doesnt know what the right is doing....all of our institutions are set up illogically and unhealthily imho
Why doesn't this make me feel more confident? The UBS story just gets worse.

It may be significant that previous lapses in risk management were solved by: A) merging with rival Swiss Bank (when LTCM blew up); B) a Swiss government bailout after 2008.

If management can't figure out their net worth within a billion or so, how should investors evaluate them?

"You can't expect us to keep tabs on every young employee slinging a measly couple of billions around."
UBS keeps lowering my expectations for financial institutions. Now, their reported loss is up another $300,000,000, not counting the effects of adverse publicity. By reassuring me that this took place in only 3 months, they raise new questions about internal controls. One employee can lose $2.3 billion in three months before anyone notices? This conflicts with charges filed saying his false accounting began three years ago.

He was trading positions in "global synthetic equities". These are complex financial products based on index futures. It appears he was given instructions to hedge the transactions, but left one side of the positions uncovered. Had he guessed right he could have made more money than he would be likely to spend in a lifetime. The next question on my mind is "assuming he succeeded, how did he expect to get the money out of the bank?"

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