Background

A couple of months ago — near the end of my PhD — the last five brain cells not taken up by my thesis came up with a tricky question: What will you do after your PhD? Immediately, I came up with the only good answer: I don’t know. My brain cells responded: Hmm - OK. But where do you want to live?. Dammit, good question! - I replied. As the good man I am - I of course sought my girlfriend’s help for this question and after some thought we decided to move temporarily to Vancouver, BC. Question solved!, I thought at first. Oh no - question postponed…, my five brain cells replied. Since my girlfriend and I settled on an agreement (mainly forced by our parents), that we will return to Germany some time in the future, the question was not answered yet.

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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