This is a guest post from Rick, the author of Invest In 2012, a website dedicated to providing investment and financial opinions.
Remember LTCM, the investment fund with Nobel geniuses that exploded in 1997? If you’re not familiar with the story, they were basically a highly leveraged hedge fund (leveraged 100 to 1) that imploded in spectacular fashion in 1997 when the Russian government defaulted on it’s bond payments). So here’s what you can learn from them.
1) Leverage is best not to be used, especially if you’re a big fund. If the markets are going against you, then you have to be able to hold onto you’re position until the market turns around and proves that you’re right. To do so, you can’t have leverage because the instant the market turns south, you’re going to be hit with massive margin calls. And if you’re a big fund, you’ll realize that market liquidity dries up when the market panics, because everyone is trying to sell, and there are not enough buyers to go around.
2) You can’t use logic in a crazy country. LTCM (Long Term Capital Management) tried to apply it’s trading model in Russia. Russia@ That crazy country where everything is run by ogliarchs and fat government cats! Trading models (the computer models that LTCM deployed) work based off of historical data, and work best only in free economies (such as the United States).
3) Hubris breeds ignorance, which will lead to one’s downfall. The LTCM guys were all Nobel prize winners, so they believed that their market predictions simply couldn’t be wrong! Long story short, they were wrong, and their fund exploded. Even men with genius IQ’s are wrong. And if you’re leveraged heavily, all it takes is to be wrong once, and then you’ll be wiped out instantly.
See Rick’s great post on What It’s Like To Rent Your Basement.