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My accidental lesson on leverage

I learn far more from what I screw up than what I get right. For instance, when I created Cat Stock Blog I started a fantasy portfolio in my Wall Street Journal account. I funded it with $1,000 in fake money, but I mistakenly entered my first transaction for 100 shares of Cat at $42.33, giving myself a balance of minus-$3,233 on the first day. This the equivalent of putting $1,000 in cash down and investing the rest on margin, just like the big boys do (except when they don’t).

Every day I get an e-mail telling me my day’s returns. At first I wondered why my returns were so totally out of whack with the day’s close, the it dawned on me what was happening: The automated portfolio software was accidentally replicating the process of using leverage to juice returns.

Here’s what happened today: On a day when the market fell about 2 percent, my fake portfolio’s net worth plummeted by 13 percent. Three-to-one leverage looks risky as hell in a down market; imagine how careful/crafty/brilliant/lucky you’d have to be if you were floating 30-to-1 leverage like many of the hedge funds and investment banks did until recently.

And people were surprised that there was a crash.

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Tom Mangan posted at 1:49 pm December 22nd, 2008 |

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  1. Lessons in leverage, an update | Cat Stock Blog says:

    […] new readers: I posted an item in late December explaining how I accidentally created a leveraged stock portfolio by buying 100 shares of Cat at $42.33 but funding it with only $1,000. With $1k of my own (pretend) […]

    Permalink | Posted January 29th, 2009, at 11:35 am

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