Published on June 25, 2014
(11) BANKRUPTCY P HYSICS , A STROLOGERS , I NTEREST R ATES AND B ILLIONS OF LOSSES . The sudden plunge of Orange County, Calif., into bankruptcy shook the market for public borrowing across the country. At the time, it was the largest local government bankruptcy in U.S. history, and it served as a warning of how rapidly financial strategies can sour, leaving an apparently prosperous county unable to pay its bills. Wall Street brokered billions of dollars in loans to Orange County's investment fund. The Orange County fund specu- lated on interest rates staying low or declining. As the rates rose in 1994, the county's losses mounted. (9) It seems unlikely that any county invested quite as recklessly as did Robert L. Citron, who was forced to resign as the Orange County treasurer. Citron funneled billions of public dollars into investments that initially generated high returns, prompting cities, schools and other agencies to borrow millions of dollars to join in the investments. The strategy backfired, and Citron's investment pool lost $1.64 billion. Nearly $200 million had to be slashed from the county budget, more than 1,000 jobs were cut and the county was forced to borrow $1 billion. A grand jury later found that Citron had relied on a mail-order astrologer and a psychic for interest rate predictions. Other Orange County officials faced criminal charges in the fallout from the bankruptcy. Citron's assistant, Matthew Raabe, was convicted of fraud and misappropriation. A grand jury indicted county supervisors Roger Stanton and William Steiner for failing to safeguard public funds. (10) USING FINANCIAL INFORMATION , TOOLS , AND MODELS FINANCE SEEKS TO DISCOVER AND IMPLEMENT ‘ OPTIMAL ’ SOLUTIONS BALANCING “ EXPECTED VALUE ’ WITH “ EXPECTED RISK ”. (14) Finance views the world as a collection of decisions about some combination of value and risk. In respect to investments value can be defined as expected future cash flows and risk as the possible deviations from those expected cash flows. (7) The graph below is an example of what maximum returns while minimizing risk looks like when plotted and is referred to as the Efficient Frontier. The Efficient Frontier line starts with lower expected risks and returns, and it moves upward to higher expected risks and returns. Investments positioned along The Efficient Frontier should have higher returns than is typical for the projected level of risk. The Efficient Frontier flattens as it goes higher because there is a limit to the returns investors can expect. This financial concept compares all known value and risk combinations to discover optimal strategies for risk compensation. As risk increases investors want to be paid accordingly and the Efficient Frontier strategy is a great tool for measuring an investments expected value and expected risk. One limitation of the Efficient Frontier Analysis is the reliance on historical data and not the what-the-economy/company-will-do- in-the-future data. Its value for making future investment recommendations depends on the assumption that the investment past will repeat itself in the investment future. Therefore, The Efficient Frontier Analysis does not answer the critical investing question of which investments will be on the Efficient Frontier in the future. (15) (14) EFFICIENT MARKET HYPOTHESIS THEORY BASED ON UNPROVEN ASSUMPTIONS AND RATIONAL EXPECTATIONS The EMH has proven to be the most wildly mis-specified theory in the history of finance, and the most expen- sive. Without it, we would have recog- nized market dysfunctionality and instituted more controls to help limit the wild expan- sion of the financial business. We might easily have steered clear of the three-sigma (100-year) bubbles in tech and U.S. housing that led to the most recent crisis. Independent investors can’t easily dis- tinguish talent from luck or risk taking. It’s an unfair contest, nothing like the fair fight assumed by standard Eco- nomics. As the finance industry adds new products, options, futures, CDOs, hedge funds, and private equity, aggre- gate fees per dollar rise. As the layers of fees and layers of agents increase, so too products become more compli- cated and opaque, causing investors to rely increasing on the finance industry for guidance. The client world pays up precisely in proportion to how bamboo- zled it is by unnecessary complexity and this, among other negatives, is what many financial professionals are offering: confusion, doubt, and bam- boozlement. (6) DO NOT UNDERESTIMATE THE SCALE OF THE DISASTER CAUSED BY FANCY NEW INSTRUMENTS AND A BELIEF IN MARKET EFFICIENCY .