closer to your maximumloss amount, it is imperative that you cut your risk so that you don’texceed  the  economic  stop-out  level  to  which  you  have  committedyourself.
• By contrast, as profits accumulate, you move farther away from youreconomic  stop-out  and,  thus,  have  the  prerogative  to  either  increaseyour exposures or take on new types of market risks that may expandyour trading horizons in the future.
In previous chapters, I have suggested that a fully invested risk posi-tion is one where a one-standard-deviation market fluctuation (occurringin roughly one out of every three market days) does not cause you to lose(or gain for that matter) any more than 10% of the sum of your risk capi-tal  plus  your  year-to-date  P/L.  For  example,  if  you  have  committed  to  aprogram under which you will not lose more than $100,000, then on dayone, I would say you are fully invested if the standard deviation of yourreturns  is  $10,000  or  less.  As  profits  accumulate,  this  number  goes  up,such that if you make an additional $100,000, you are then $200,000 awayfrom your stop-out and can be comfortable with standard deviations of upto  $20,000.  By  contrast,  if  you  lose  $50,000,  you  are  $50,000  away  fromyour stop-out, and I would recommend that your standard deviation neverexceed $5,000. 
There are many benefits to operating under this approach, which, per-haps as much as any other topic covered in this book, I’d like to drill intoyour  psyche.  With  benefits  come  responsibilities.  Above  all,  portfoliomanagers have an obligation to dampen their risk profiles during periodsof  accelerating  negative  performance.  I  have  alluded  to  several  reasonswhy it is in your best interest to reduce exposures as return profiles dete-riorate,  and  these  reasons  are  so  important  in  my  mind  that  they  bearrepeating in the concluding portions of this book. 
First and most important, if you are trading professionally (using otherpeople’s capital and receiving a percentage of the profits), there is a point
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of  negative  P/L  beyond  which  your  interests  and  those  of  your  capitalprovider begin to diverge. This comes when you start to perceive that yourcompensation cannot go lower with incremental negative P/L and cannotgrow unless you make up your deficit in rapid fashion. The clear expedientfor those of this particular mindset is to increase their exposures, becausethe incremental benefits from being right (at least at a superficial level) farexceed the additional costs of being wrong. 
On  the  one  hand  (the  worse  one),  you  might  lose  your  funding  alto-gether (i.e., you are unceremoniously defrocked); but this is a realistic out-come only for traders who are in significant negative P/L territory anyway.On the other hand, if things work out for you at higher risk levels, you arelikely to be back in the black much sooner and thus reap compensation foryour efforts in a much more expeditious fashion.
If you are trading in deficit, you will face a great temptation to increaseyour exposures; but your capital provider is in the exact opposite position.This entity clearly suffers with every incremental dollar you lose—more soif  it  is  funding  multiple  trading  enterprises  and  bearing  the  netting  risk.This is why your desk manager is all over you to cut your risk when youare dropping cash. I would argue not only that is the capital provider cor-rect in this mindset, but also that its desire to cut exposures serves both itsbest interest and yours. Seldom have I seen the strategy of ratcheting uprisk for those in deficit pay off the way that the trader/investor hoped; andeven when it has, it encourages behavior that is likely to be destructive tothe portfolio manager in question over the long term. 
Drawdowns are as inevitable in trading as fumbles are in football; andthose who respond to drawdowns with prudence can have a long, happylife in portfolio management, while those who go the opposite route willeventually flame out—albeit, perhaps, in spectacular fashion.
WHO IS GOING TO MAKE IT? WE’LL FIND OUT, IN THELONG RUN.
These days, no risk management book is complete without an analysis of thedemise of Long-Term Capital Management (LTCM). I’m sure we all agree that theworld needs yet another synopsis of these events, in which a handful of traders,operating from an obscure outpost in Greenwich, Connecticut, and managing afew  billion  dollars  of  highly  levered  capital,  threw  the  global  financial  systeminto a state so dire that it could only be solved by that most improbable of prob-lem-solving methods: government intervention. What is more, I figure I’m justthe guy to provide it. After all, I was managing risk at a hedge fund of similarfocus (if more discipline), whose wings also got singed a bit in the cross fire ofthese events but who rose to much greater heights in their aftermath.
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Besides, the topic is simply too juicy to resist. I don’t know of anyone I’veever encountered in the financial services industry that did not have great admi-ration  for  the  LTCM  team.  Its  leader  John  Meriwether,  is  responsible  fordramatic  advancements  in  the  field  of  relative  value  fixed  income  trading—astrategy that many (including this reporter) believe to be both viable and vitalto this day. My own personal case of blind devotion, deriving largely from mystatus as a wanna-be academic, was and still is skewed towards Robert Mertonand Myron Scholes, whose contributions to the world of modern financial engi-neering  speak  for  themselves,  and  need  no  particular  embellishment  fromyours truly.  Like Newton, their accomplishments will survive them, in my viewfor as long as the world continues to devote resources to the challenge of effi-cient asset valuation. And also like Newton, the fact that their undisputed bril-liance rendered them in no way immune from financial setbacks caused by thecaprices of the marketplace, serves as a (not so) gentle reminder to us all thatthis here game of trading and portfolio management is a hazardous one indeed.So let’s take another look, shall we? Our cast of characters features an elitetrading team, bones made on the vaunted Salomon Brothers fixed-income trad-ing desk, universally regarded as the 1927 Yankees of proprietary investment.Intellectualized by the addition of some of the pioneers of financial engineering,legitimized by a former vice chairman of the United States Federal Reserve, andfawned  over  by  a  global  financial  services  community,  LTCM  was,  in  everyrespect, larger than life. Though no one outside the firm knew the extent of theiroperation  until  it  blew  sky-high,  after  the  fact  it  was  plain  that  their  financialambitions outstripped even their seemingly unsurpassable collective credentials. The story of how it all came crashing down—how this group managed firstto practically corner the market on an unimaginable array of global securities;then to watch helplessly, unable to liquidate, as this portfolio dropped billionsin value over a matter of days (in the process nearly taking down a good portionof the world’s leading capital markets institutions); and ultimately to create a sit-uation that required government intervention to avert a global market crisis—isa matter of prolific public record. However, there are some mouthwatering tid-bits here, so bear with me for a few more paragraphs, and you’ll not be sorry.
For the uninitiated, Long-Term Capital Management was a hedge fund con-cern  created  by  John  Meriwether  (former  vice  chairman  of  Salomon  Brothers).LTCM applied the trading techniques that (to give the man his props) JM had pio-neered, this time in a private funding vehicle, where he wouldn’t have to be both-ered by issues like regulatory oversight and shareholder concern about earningsvolatility.  Their  specific  strategy  was  something  called  “relative  value”  invest-ment, under which investors seek to identify small discrepancies in the valuationof securities with similar characteristics, buying the cheap one and selling theexpensive one, under the expectation that the two will ultimately converge.
In the mid-to-late 1990s, LTCM was ubiquitous in my world, kind of likeMichael Jackson a decade earlier. Indeed, even five years after their infamous
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demise, I find it difficult to escape the shadow they cast. The derivatives groupat the bank I once worked at had cut their teeth at JM’s desk at Salomon andhad  sold  a  potential  trading  relationship  with  LTCM  to  management  of  thebank as though it was a matter of high honor and privilege. Later on, when Iwent over to the “dark side” and joined a hedge fund myself, LTCM was heldup to be the ideal to which the rest of the industry should aspire. When theirday of reckoning came, in early autumn of 1998, I was responsible for the riskmanagement function of portfolios that had similar components but much bet-ter construction than the one put together by the Nobel laureates, Fed gover-nors, and market visionaries that are the subject of this study. Suddenly, every-one became very interested in what hedge funds were doing and how we weredoing  it.  Later,  when  the  fallout  from  the  LTCM  incident  had  worked  its  waythrough the financial system, we all paid a price, lectured to on risk manage-ment  topics  by  those  with  only  the  most  rudimentary  understandings  of  theconcepts discussed in this book. Finally, nearly five years after the original inci-dent, I find myself unable to resist the temptation of featuring the LTCM boysin my final case study.
A full year before the highly publicized collapse, LTCM was managing a thennearly  unheard-of  $7  billion.  They  had  managed  to  average  for  the  three  prioryears of their existence a net return of 40%, near as I can tell, capitalizing, at leastin  part,  on  two  very  discernible  trends  in  the  marketplace:  European  Monetaryconvergence and the steep decline in U.S. interest rates. As 1997 drew to a close,these  trends  appeared  to  be  running  out  of  steam.  Interest  rates  not  only  inFrance  and  Germany  but  indeed  in  all  European  Monetary  Union  nations  weremoving in lockstep, and the well was running dry in terms of playing these ratesagainst each other. Moreover, the U.S. Federal Reserve, which had been loweringinterest rates aggressively since the recession of 1991, was looking like it wasready to stand pat for a while (though, as we now know, not for a very long while).In short, the practice of capitalizing on relative pricing inefficiencies in theworld of global fixed-income arbitrage was looking like a less lucrative one as1997 drew to a close, and the LTCM boys did something that looked both dar-ing  and  brilliant  at  the  time:  They  decided  to  give  back  half  of  the  $7  billionthey had under management.
“Damn, them buzzards are smart!” I remember thinking at the time (whenI talk to myself, I often do so with a southern drawl). The spreads in their mar-kets  were  narrowing,  their  risk  reward  curve  was  shifting  inward,  and  theresponsible thing to do was to scale back their program to the lower level ofopportunities in the market. Moreover, it was plain to see that the process ofreturning capital was far from painless. By all accounts, many of their investorstook the news of their redemption as a matter of high betrayal. Nevertheless,the process went through as anticipated; and it appeared from my perspectivethat entering into the fateful year of 1998, LTCM was well positioned to con-tinue to generate solid, if more earthbound, levels of risk-adjusted return.
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Then the bottom fell out, and a much different kind of story emerged. Itturns out that LTCM hadn’t scaled back its exposures at all; in fact, they hadby all accounts increased them dramatically. The return of some $3.5 billion ofinvestor  capital  was  not,  as  subsequent  events  proved,  driven  by  a  desire  tooperate  at  lower  levels  of  investment  in  the  face  of  reduced  opportunity  set,but was simply a part of a plan on their part to increase the leverage of theirproprietary investment program! While I obviously cannot speak with accuracyabout their mindset, this appears to be the only logical explanation, becauseas we learned in the unwind, they were scaling up their position sizes in a sus-tained fashion, both at the time of their capital reduction and for months afterthe fact. What was worse, several of the partners in the firm had actually bor-rowed  very  aggressively  in  order  to  maximize  their  investments  in  the  part-nership.  The  end  result  of  these  confluences  was  that  individuals  who  wereconsidered  among  the  brightest  lights  in  the  whole  investment  industry  hadborrowed money to invest in a fund product that was itself trading in a highlylevered fashion, financed through credit arrangements with banks and brokerdealers. For these partners, every dollar of actual capital that belonged to themappears  to  have  been  mapped  into  literally  hundreds  of  dollars  of  marketinvestment. Nobel laureates or not, this requires a heady amount of confidencein one’s ability to predict the future.
Lesson one of this tragedy is about identifying the appropriate responseto  changing  risk/reward  characteristics  in  the  markets  in  which  you  areinvested. When the risk/reward curve shifts inward on your portfolio manage-ment program (as it invariably will over the course of a long career in the mar-kets),  your  choices  boil  down  to  either  maintaining  current  exposure  levelsand  accepting  a  lower  return  or  increasing  your  risk  to  the  point  where,  ifthings work out in your favor, you can preserve your historical performance.If you choose the former path, you may have periods of modest results; butyou are likely to remain solvent and, perhaps more important, to preserve cap-ital  to  deploy  when  the  risk/reward  curve  shifts  outward  again  (as  it  usuallywill). Conversely if you adjust your risks upward to meet target performancelevels, if the gods are smiling on you, this trade may work out. However, bydoing  so,  you  are  most  certainly  placing  yourself  at  the  mercy  of  eventsbeyond your control; and as I have argued throughout these many pages, thisis precisely the condition you want to avoid. No one understood these trade-offs better than the LTCM crew; yet their failure to adhere to these core prin-cipals is one of the main reasons why their ship, widely thought to be unsink-able, hit that iceberg.
Lesson two, which pertains to liquidity management, also became appar-ent only when sifting through the wreckage. The size of the Long-Term port-folio turned out to be astonishing—not only when compared to the amount ofcapital available to fund it, but also in terms of its dominance of certain assetand instrument classes. While the combined value of on- and off-balance-sheet
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instruments was almost incalculable, it was clear that the fund owned, or heldshort,  an  alarming  percentage  of  the  float  of  certain  financial  instruments.This  included  frightening  portions  of  the  entire  debt  issuance  of  individualcountries. When events beyond their control (most notably the Russian defaultof  August  1998)  caused  their  positions  to  move  against  them,  they  wereunable to effect risk reduction through liquidation because, quite simply, noother market participants, not even the global financial institutions that weretheir trading partners, had the financial or risk capital to take the other sideof these trades. Note that this problem occurs in all markets for anyone whotakes control of too large a portion of a single set of assets. Think of a realestate  speculator  who  buys  up  an  entire  neighborhood  and  then  has  to  selllots for reasons of financial duress. Is he going to get a good price for theseassets? Not likely.
The critical mistake made by the LTCM brain trust was that their positionsize went well beyond what the liquidity of the markets would bear. Moreover,they  didn’t  do  this  just  in  one  or  two  financial  instruments,  but  rather  indozens and perhaps hundreds of markets. In their own postmortems on theevents of the fall of 1998, Meriwether and his partners will tell you that thereal problem was that everyone in the market knew their positions and usedthis information against them. This is only partially true: While many marketparticipants knew what instruments LTCM was trading, almost everyone wasstupefied by the size of their positions. Moreover, that information about theirspecific  positions  was  widely  available  to  market  participants  was  aninevitable result of their overaggressiveness in the market. If you are going toassume  positions  that  represent  50%,  60%,  sometimes  approaching  100%  ofthe  issuance  of  esoteric  securities  such  as  Danish  Mortgage  Revenue  Bondsand the sovereign debt of the Czech Republic, other market participants arebound to notice. To expect them to ignore the fact that you are trying to liq-uidate  positions  that  you  have  been  accumulating  for  months  is  to  ask  tooperate outside of the financial world that made you wealthy beyond measurein the first instance.
Since the debacle, most of the partners of LTCM have moved on to greenerpastures.  Several  of  them  started  a  risk  management  consultancy  practice.Some of the academics went back to their ivory towers. As for JM, he startedanother hedge fund, this time targeting more modest returns at lower leveragefactors. 
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The investors who are funding your portfolio, whether they be the cus-todians of a money management institution, individuals who have trustedtheir  personal  capital  to  you,  or  some  other  profile,  will  be  mindful  andappreciative of the care you have taken with their assets and will rewardyou in the long term by more permanently entrusting you with your port-folio management responsibilities. In my experience, these entities under-stand the conflicts that arise when you hit a bad stretch (as you are welllikely to) and will allocate their discretionary capital to those who manageit prudently, with their interests in mind. A trader who is looking to get faton other people’s risks is a bit like the proverbial and much-maligned used-car  salesman.  Ultimately,  customers  see  through  his  angle  and  deal  withhim as little as possible. Note that in many cases, it is possible for both toenrich  themselves;  however,  no  one  rationally  mistakes  their  efforts  forhigh-quality professional service.
Some of the dynamics involved in managing other people’s money arealso  at  play  for  those  trading  their  own  capital.  Here,  instead  of  cominginto conflict with an external funding entity, you will find yourself person-ally torn between the objectives you have as a manager of your own per-sonal wealth and your desire for success in the markets. Though perhapsmore  subtle  in  nature,  these  conflicts  can  be  every  bit  as  destructive  asthose between the professional portfolio manager and the source of his orher  capital  funding.  Certainly,  the  internal  strife  you  may  suffer  in  thisregard cannot be constructive to your decision making in the markets, andit can often cloud judgment in ways that are catastrophic to your financialwell-being.  Of  course,  if  you  reduce  your  exposure  in  times  of  difficulty,you obtain multiple benefits, including capital preservation, the ability tocontinue to participate in the markets, and the confidence that your trad-ing and investment activities are not likely to damage your financial profilebeyond repair.
One more thing I’d like to reinforce about the concept of risk reduc-tion in the midst of a drawdown: If you have hit your loss limit, stop trad-ing. The breaching of this threshold means one thing and one thing only—the  game  is  over  and  you  have  lost.  The  only  question  that  remains  iswhether you want to play again in the future. If the answer is yes, then yourpath is clear. By contrast, if you refuse to capitulate under the rules thathave  been  established  at  the  outset  (i.e.,  your  account  won’t  lose  morethan X), then in addition to any incremental damage you may suffer to yourfinancial  or  professional  well-being,  I  can  state  for  sure  that  you  areheaded down a path where your trading prerogatives will belong to others(e.g., creditors or angry employers), and not to you.
Now  let’s  take  a  final  look  at  the  sunny  side  of  the  egg,  namely,  theadditional risk-taking capacity that is available to you during and immedi-ately after intervals of sustained profitability. Just as your losses bring you
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closer to your economic stop-out, so do gains separate you, in terms of P/L,from your maximum-loss threshold. Thus, one of the many happy implica-tions of positive returns is that it adds, dollar for dollar, to your risk capi-tal as we have defined it throughout this book. While I have described riskreduction during drawdown as being an imperative, I would characterizethe concept of increased risk taking after a run-up as being a prerogative.Specifically, rather than stating you must increase exposure as risk capi-tal increases, I would tell you that you can accept higher risk levels; and inspecific situations, I would more emphatically suggest that you ought to.To review our rationale: Positive P/L creates a risk cushion that allowsyou to think more expansively about your portfolio management activitiesand provides the ideal framework for some portfolio experimentation. Thismay  take  the  form  of  larger  position  sizes  and/or  longer  holding  periodsthan  you  would  consider  comfortable  when  you  are  flat  or  down.  Or  itmight involve everything from dabbling in new markets or instrument typesto testing out new counterparty relationships. I have suggested that the bestway of exploring these new horizons is to frame them in the form of a con-trolled experiment, under which you set aside a specific portion of the rev-enues you have generated that you are willing to risk in an effort to expandyourself as a portfolio manager. Set up a separate account, if necessary, tocapture  this  activity;  and  by  all  means,  use  the  statistical  tools  I  havedescribed in this book as a way of measuring your relative success in thesenew activities. If you lose an amount equal to what you have established asrisk  capital  for  these  efforts,  discontinue  the  strategy  and  go  back  to  thecore of what was working for you. If the new stuff juices you and makesyou better in the markets, let the fair winds blow you where they may.
The  best  portfolio  managers  I  know  all  define  their  experiences  interms  of  these  types  of  risk/reward  cycles,  delevering  during  drawdownand seeking to expand their horizons when times are good. The payoff youwill derive from this ebb and flow takes the form of allowing you to maxi-mize  your  adaptability  to  everchanging  market  conditions:  You  will  havethe ability to weather most times of tribulation for your trading activities,and  you  will  find  yourself  with  a  much  broader  set  of  methodologies  tooperate successfully as markets evolve.
AVOID SURPRISES—ESPECIALLY TO YOURSELF
If you buy into the methodologies we’ve discussed, you should be in a posi-tion where pretty much everything that happens to your portfolio is withinthe range of normal expectation. Of course, there will be exceptions to thisrule. For example, if you found yourself, on September 11, 2001, with a lot
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of airline and insurance company exposure, the losses you may have expe-rienced when the markets reopened the following week would have beendifficult  to  anticipate.  Don’t  blame  yourself  too  much  if  this  happens,  asyou will have clearly been the victim of events beyond your control. If yousized your portfolio exposures appropriately, you should be able to handlethe attendant volatility, and my guess is that the next roll of the dice willwork in your favor.
More  important,  absent  these  types  of  market  events,  the  risks  andrewards  you  take  in  the  marketplace  should  be  at  all  times  quantifiable.This rule applies both to institutional money managers and to those trad-ing their own capital. In each case, the concept of P/L fluctuations beyondwhat had been specifically anticipated is one that reduces confidence andinspires smaller, not larger, money management mandates. It is critical toat all times be cognizant of the P/L ranges that are likely to govern yourtrading.  If  you  find  yourself  surprised  by  a  given  outcome,  you  shouldstrive to figure out the reason why and to put measures in place to guardagainst recurrence. If you’re trading professionally, you never want the riskcontrol elements of your funding entity to be surprised either. They needto understand your portfolio dynamics and will feel very burned if eventsoccur in your account that neither you nor they had anticipated.
What types of market and portfolio dynamics lend themselves to sur-prise outcomes? In my experience, the primary culprits are markets withnonlinear pricing patterns. This most prominently includes derivative mar-kets; and generally speaking, it is fair to conclude that the more compli-cated the derivatives portfolio, the higher the likelihood for unpredictableresults. You should, as a matter of core principal, avoid trading any deriv-ative  instruments  (or  combination  of  derivative  instruments)  where  youdon’t fully understand not only the range of outcomes, but also the associ-ated causes and effects.
It is not sufficient to understand the boundary conditions of derivativetrading; you should avoid these markets unless you understand well whatmay happen to your portfolio inside these boundaries. For example, port-folio managers of every level of sophistication are comfortable purchasingoptions  because  they  know  that  their  losses  are  limited  to  the  amountinvested  in  the  options’  premium.  Is  this  sufficient?  Not  in  my  view.  I’veseen way too many portfolios that have died a slow death by purchasingoption after option that indeed hit that (admittedly identifiable) worst-casescenario. It is necessary to have a much higher degree of understanding ofderivative  pricing  dynamics  than  worst-case  loss  prior  to  having  a  suc-cessful derivatives portfolio model.
Even portfolios that are comprised exclusively of securities that have lin-ear pricing characteristics can offer surprises that serve as red flags to theportfolio  management  process.  More  often  than  not,  this  occurs  when  the
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securities contained in the portfolio move in abrupt and surprising ways—largely  due  to  the  unanticipated  impact  of  new  information  in  the  market-place. Just as you don’t want to trade derivatives if you don’t have a very pre-cise  handle  on  how  they  may  react  to  the  full  range  of  likely  marketconditions, so too is it sinful to be trading cash securities that lend themselvesto discrete price movement not contemplated within the portfolio strategy.
What happens, then, when you own a security on which you’re willingto risk 5%, hoping it will rise by 10% but instead it drops 20%? If it happensrepeatedly,  I  can  only  describe  it  as  a  breakdown  of  your  portfolio  man-agement program. Take a hard look at the factors that caused the correc-tion. Were they anticipatable (e.g., tied to an earnings release or other fore-seeable  event)?  If  so,  it  suggests  that  you’re  not  doing  as  muchfundamental work as you need