THE BEST WAY TO UNDERSTAND THE GLOBAL FINANCIAL SYSTEM 169
After the collapse and rescue, I chatted with one of the
LTCM partners who ran the firm about what went wrong. I
was familiar with markets and trading strategies, but I was not
expert in the highly technical applied mathematics that the
management committee used to devise its strategies.
The partner I was chatting with was a true quant with ad-
vanced degrees in mathematics. I asked him how all of our
trading strategies could have lost money at the same time, de-
spite the fact that they had been uncorrelated in the past. He
shook his head and said, “What happened was just incredible.
It was a seven-standard deviation event.”
In statistics, a standard deviation is symbolized by the
Greek letter sigma. Even non-statisticians would understand
that a seven-sigma event sounds rare. But, I wanted to know
how rare. I consulted some technical sources and discovered
that for a daily occurrence, a seven-sigma event would happen
less than once every billion years, or less that five times in the
history of the planet Earth!
I knew that my quant partner had the math right. But it
was obvious to me his model must be wrong. Extreme events
had occurred in markets in 1987, 1994 and now 1998. They
happened every four years or so.
Any model that tried to explain an event, as something
that happened every billion years could not possibly be the
right model for understanding the dynamics of something that
occurred every four years.
From this encounter, I set out on a ten-year odyssey to
discover the proper analytic method for understanding risk in
capital markets. I studied, physics, network theory, graph the-
ory, complexity theory, applied mathematics and many other
fields that connected in various ways to the actual workings
of capital markets.
In time, I saw that capital markets were complex systems
and that complexity theory, a branch of physics, was the best