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I’ve run monte carlo simulations for Banks. I’ve done Stress Tests for Banks. I’ve built acquisition models for M&A. The principles for that and various scientific models are the same.

There was a great documentary called “Trillion Dollar Bet” about Long Term Capital Management in the 90s. That was a company formed by some math whizzes who figured out the Black Sholes model for calculating the value of European Call Options. Its beautiful math. They won a nobel prize in economics for it. Long Term Capital Management was a big success because it could more accurately calculate the value of these options by tiny fractions of a decimal point than the market had been able to do before.

Then the Tech bubble burst and the market went down and Long Term Capital Management went bust and had to be taken over by the government lest it contaminate the entire market. What happened?

Simple. The math whizzes who ran the thing did not know what a bear market was. They thought it was a market in which prices are going down. Nope! A bear market is a market in which there is no liquidity. What does that mean in English?

Their formula said when the price goes down a certain amount you sell. The projection was somebody else buys and others take that elevator ride all the way down to hell. That’s not what happened. The price went down and LTCM put their options up for sale and nobody bought. So they reduced the sales price and nobody bought. So they reduced the sale price more and nobody bought. and on and on. Uh oh. They were stuck with crap assets and they took that elevator ride all the way down.

Effectively the assets they were dealing in were more risky than they had priced them as. The government took over, the assets recovered after a little while and the government got out without suffering a huge loss but this was a perfect example of the most beautiful math in the world (Black Sholes which is still used today) but bad assumptions leading to utter disaster.