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• Saturday, August 18, 2007 07:03 AM

  The lesson of the crash of 1929

  The three lessons from history are that leverage always works both ways; diversification is often an illusion in times of overall decline; and every seller needs a buyer most when one can't be found.

  If there is any similarity between the current sub-prime illiquidity situation and the crash of 1929 it in the flow of investments from highly regulated investment vehicles to unregulated investments that are more highly leveraged.

  We should heed as a painful reminder that the crash of 1929 was not simply the story of falling stock prices, but also the coming home to roost of the highly leveraged investment trusts that were the fashion of the day.

  Like the derivatives of today's investment world, these investment trusts (the precursor to mutual funds) became a highly leveraged investment when traders started to create investment trusts that invested not in individual stocks but instead invested solely in other investment trusts. Thus giving you an investment trust made up of a basket of other investment trusts. On the surface this offered more diversity, but in the face of a rapidly declining market these trusts popped like balloons when buyers evaporated. Trusts that bought other trusts in the declining market in the logic that stocks were getting cheaper disappeared even faster.

  —MrPibs Read MrPibs's other letters
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