When Traders Get Things Right

One of the best books on business is "When Genius Failed" by Roger Lowenstein. It is the the story of the spectacular and scary 1998 blow-up of the hedge fund Long Term Capital Management.

Although the book focuses on the financial markets, it offers lessons for business in general. My favorite passage:

"Even when traders get things 'right,' markets can hardly be expected to oscillate with the precision of sine waves. Prices and spreads vary with the uncertain progress of companies, governments, and even civilizations. They are no more certain than the societies whose economic activity they reflect. Dice are predictable down to the decimal point; Russia is not; how traders will respond to Russia is less predictable still. Unlike dice, markets are subject not merely to risk, an arithmetic concept, but also to the broader uncertainty that shadows the future generally. Unfortunately, uncertainty, as opposed to risk, is an indefinite condition, one that does not conform to numerical straight jackets."

The broader business moral in the story of Long Term Capital Management is that the world is far less stable and predictable than we care to admit. Finance and accounting make the world manageable, but they do not necessarily make the world more predictable. This is true because finance and accounting are themselves a subset of the way the human mind sorts through large seas of data in search of signficant details, a process science defines as cognition.

Cognition creates a sense of order in the universe that is tremendously useful for accomplishing many tasks. But it is dangerous to assume that that particular sense of order is all there is, or that it will capture all the significant details, or that it will remain permanently useful.

Cognition is like a map. A map is useful because of what it includes, and because of what it leaves out. When circumstances change, it can be worthless for the same reasons.