Figure 1: Even brilliant economists can gamble away money.

“Source: Edwards, F. R. (1999). Hedge funds and the collapse of long-term capital management. Journal of Economic Perspectives, 13(2), 189-210.”

Introduction

My preparations for the review of the book Money Magic by Laurence J. Kotlikoff led me to sink into a Wikipedia rabbit hole. Especially the time in which I tried to grasp the ideas behind the Merton–Samuelson theorem led me to consult the Wikipedia pages of Robert C. Merton and Paul Samuelson for hours and hours, impressed by their huge contributions to economics as a science. However, one instance in the life of Merton interested me in particular: his involvement in the hedge fund Long-Term Capital Management (short: LTCM), whose collapse in 1998 almost led to a global financial disaster. Curious about the matter and not fully satisfied with the corresponding Wikipedia page, I fortunately found the well-written article Hedge Funds and the Collapse of Long-Term Capital Management by Franklin R. Edwards. The article not only describes the timeline of the LTCM collapse in an interesting fashion, it also explains the functioning of hedge funds and why they can fail. So let’s dive into it.

“I once asked a roomful of economists — all of whom were gathered to discuss household personal finance — to answer, on the fly, the consumption-smoothing question for a hypothetical forty-year-old. I gave them the pertinent information and watched their faces. They weren’t happy. They knew they were about to produce a very wrong answer. Right then and there, they seemed to realize that even financially literate people like themselves couldn’t make proper financial decisions via introspection.” (p. 6)

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Context: The idea for this meme came to me during the process of applying to a company active in the financial market. I remembered the time when, as a student, I was already searching for big money and believed I would find it at a financial distribution firm.

One of the sales arguments back then was the so-called Cost-Average Effect (in German: Durchschnittskosteneffekt, also referred to in English as dollar-averaging effect). This concept describes regular investments of fixed amounts into (volatile) securities, where price fluctuations lead to purchasing shares at a lower average price. When prices are high, fewer shares are bought; when prices are low, more shares are purchased, so that per share the harmonic mean rather than the arithmetic mean of prices is paid. Or put differently: price losses weigh less heavily because through regular purchases of shares, more shares are acquired during bad periods, allowing for stronger participation in future price gains. It therefore reduces the risk of loss of such investments - at least that is the theory.

Context: This meme really speaks to me. My experience as a PhD student was that typical contract durations are poorly aligned with the amount of time it takes today to publish academic articles.

PhD students are often expected to complete their doctorate within three (or slightly more) years—ideally with several journal publications. At the same time, many of these papers spend what feels like an eternity under review. From my perspective, the core problem is not the long review times themselves. Especially today, careful and thorough peer review is both necessary and desirable.

Context: I use this meme in an exercise on time-inconsistent decision-making in behavioral economics. It clearly illustrates how individuals who heavily discount their future utility and who fail to predict their own later decisions are potentially worse off than sophisticated decision-makers, who realistically anticipate their future (lack of) self-control.

Context: I use this meme in an undergraduate exercise on probability weighting as a segue into Prospect Theory. I find it particularly fitting because it also symbolizes how some classical economists react to the insights contributed by behavioral economics.

Context: I use this meme for an exercise in a bachelor-level course on sequential games to illustrate how this type of game can lead to pareto-inferior outcomes.

Context: I use this meme as an engaging opener for a bachelor-level microeconomics exercise on decision-making under uncertainty and risk. In that session, I explain the fundamentals of expected utility theory. Among other things, the students have to calculate the fair price of a German lottery ticket (6aus49). Since the German Lotto is comparable to Powerball, I’ve adjusted the meme slightly for my U.S. audience. 😉