When a trade blows up disastrously, we tend to start with a question: What did the trader get wrong about the investment itself? Shouldn’t it have been obvious that demand for a company’s product was falling? Or, wasn’t it apparent that the recent trend in interest rates couldn’t hold forever? The same holds true when things go spectacularly right—everyone looks for evidence of savvy and perception. We’re inundated with articles about how the investor saw the potential in a business Wall Street had written off or spotted a danger everyone else had minimized.
Rarely does anyone write a profile about the brilliant money manager who consistently gets the size of their investments right. Yet the decision of how much to wager is at least as critical as deciding what to invest in. If you have a knack for picking strong investments but tend to bet too much on them, a few unlucky breaks can wipe out your assets and knock you out of the game. We both have learned this lesson through a tough experience. One of us—Victor—was a founding partner in Long-Term Capital Management, the large hedge fund that suddenly lost more than 90% of its money in 1998. Fearing a disorderly unwind and contagion, the New York Federal Reserve convinced banks that LTCM traded with to put in $3.6 billion and take over the fund. The LTCM experience prompted multiple books and numerous articles about how the fund’s investment ideas went badly wrong. But less has been written about the sizing of those trades—or an approach to sizing that would have led to a happier outcome.
