Before there was the 2008 financial crisis, there was Long Term Capital Management, a hedge fund run by a small group of people that almost brought down the global economy. It foreshadowed quite a bit of 2008. Roger Lowenstein's "When Genius Failed" chronicles LTCM and is required reading to see the interplay between models and behavioral reality
Here is a summary from Warren Buffett: "The whole LTCM story is really fascinating. If you take John Meriwether, Larry Hildenbrand, Victor Haghani, the two Nobel prize winners: Merton and Scholes, if you take the sixteen of them, they probably have as high an IQ as any sixteen people working together in one business in the country, including Microsoft or wherever you want to name. Incredible amount of intellect in that room.
Now you combine that with the fact that those sixteen had significant experience in the field that they were operating in. This was not a bunch of guys who made their money selling men's clothing and then all of a sudden went in the securities business. In aggregate the sixteen had probably 350-400 years doing exactly what they were doing.
And then you throw in the third factor, that most of them had virtually all of their very substantial net worth in the business. So they had their own money up. Hundreds and hundreds of millions of dollars of their own money up.
Super high intellect, working in a field they knew and essentially they went broke. That to me is absolutely fascinating. If I ever write a book its going to be called 'Why Smart People Do Dumb Things' My partner says it should be autobiographical.
And these are perfectly decent guys, they helped me out at Salomon. They are not bad people at all. But to make money they didn't have and didn't need, they risked what they did have and did need. And that's foolish. Is just plain foolish, it doesn't make any difference what your IQ Is. If you risk something that is important to you for something that is unimportant to you, it just does not make any sense. I don't care if the odds that you succeed are 100 to 1 that you succeed or a 1,000 to 1 that you succeed. If you hand me a gun with a thousand chambers or a million chambers in it and there's a bullet in a chamber, and you say 'put it up to your temple. How much do you want to be paid to pull it once?' I am not going to pull it, name any sum you want, it doesn't do anything for me on the upside and I think the downside is fairly clear. I am not interested in that kind of a game and yet people do that financially without thinking about it very much"
What might be a better way to think about dealing with risk? Buffett's teacher Ben Graham posited ""Confronted with a like challenge to distill the secret of sound investment into three words, we venture the following motto, MARGIN OF SAFETY."
Graham defines this as "The margin of safety is the difference between the percentage rate of the earnings on the stock at the price you pay for it and the rate of interest on bonds, and that margin of safety is the difference which would absorb unsatisfactory developments." The overall mindset, assuimg unsatisfactory developments, not their absence, planning for failure, shares much in common with engineering.