I was ten years old when Long Term Capital Management (LTCM) was founded. My focus at the time consisted of acquiring more gummy worms and ruling the playground during recess. My fascination with finance was limited to scrounging up an extra $.25 to buy an additional bag of chocolate milk during lunch. Little did I know that 16 years later this exclusive hedge fund ran by luminaries would teach me the lesson of a lifetime: Leverage can kill you.
I found my recent read of When Genius Failed to be quite illuminating. I was impressed by how many parallels I could draw between the mistakes committed by LTCM and those which I’ve attempted to avoid in my own trading. The two that top the list are leverage can kill you and pride cometh before the fall.
Leverage Can Kill You. The improper use of leverage lies at the heart of countless instances of financial destruction. Like the devil it leads the unwary trader carefully down to financial hell. Both the failure of LTCM and the recent financial crisis of 2008 serve as prime examples. Leverage is a seductive sword of the double edged variety. When things are running smoothly it rewards you with much larger profits. When things turn sour it can result in the rapid acceleration of losses. The key lies in using it properly.
LTCM is a particularly egregious example of leverage gone bad. At times their assets swelled to over 50x their actual capital on hand. While this acted as rocket fuel boosting their returns in the good years, it absolutely killed them when the markets turned ugly. When leveraged to the hilt it takes a much smaller adverse move in your positions to hit your pain threshold. Had LTCM been less cavalier in the use of leverage they may have been able to withstand the short term crisis in the fall of 1998 that proved their demise.
Pride cometh before the fall. Some traders are simply too smart for their own good. Such hubris led the partners of LTCM to defer their pay (25% of the funds profits) so it would remain in the fund “where, untouched by the tax man, it could compound all the faster”. After three years they had turned their initial investment of $150 million in the fund to $1.4 billion – a staggering increase of nine fold. Rather than take money off the table, they continually redoubled their bets. After all, given their track record profits were all but a sure thing. Sadly, these profits went up in a wisp of smoke within a few short weeks. No matter how solid your past trading performance, don’t kid yourself into believing you won’t encounter some seriously adverse conditions. Placing all your money in one strategy and never taking any profits off the table is seriously stupid.
I found numerous other trading lessons illustrated by the LTCM debacle: mistaking the improbable with the impossible, investing in illiquid trading products, and straying from your tried and true strategies to more exotic territory simply because you have money to put to work.
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For related posts, readers can check out:
Options and the Volatility Risk Premium
Bailout Nation
Jim Cramer and the Grueling Routine
Achieving Creative Flow
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Tyler,
I don’t believe that straying from the tried and true was their mistake.
They were bright enough to find new profit opportunities. Their downfall was, as you say, based on too much leverage. But more than that, they could not accept the fact that they were wrong and that the world could indeed remain irrational longer than they could remain solvent (per JM Keynes).
Pride destroyed them. Too proud to manage risk.
Good thoughts Mark.
Thanks-
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