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The Repo Man

How did Robert Citron's portfolio outperform the portfolios of the other treasurers? How could he maintain safety, provide liquidity, and then earn a high return? Since you already know that he lost $1.7 billion in 1994, you won't be surprised to learn that he abandoned safety and increased the level of risk in the portfolio. In general, he did not increase the risk by buying high-risk securities (although, he twice bought some junk bonds that were prohibited. However, these were quickly sold and represented only a tiny part of the portfolio.) Contrary to the media reports, the high returns and eventual blunder were not the result of “unpredictable” and “incomprehensible” derivatives. Yet, Orange County got caught up in a media attack on derivatives. Using the Orange County incident, CBS's 60 Minutes likened derivatives to Frankenstein's monster (March 5, 1995) and Time magazine called them time bombs.[5] One column in The Washington Post even miss-characterized the problem as little more than a pyramid scheme.[6]

Instead, the culprit was a combination of investor overconfidence, optimism, and leverage. Three common investor problems! Overconfidence is discussed in Chapter 2, “Behavioral Finance,” and Chapter 12, “The Eggheads Crack”; optimism is discussed in Chapter 4, “Mood, Optimism, and Investing”; and the dangers of leverage are detailed in Chapter 12. Remember that leverage is the use of borrowed money to invest and is also called margin. Leverage magnifies your return, both positive and negative performance. Therefore, using leverage increases the risk of the portfolio. To be fair, I should point out that at least two newspaper columns got it right, one in USA Today and one in The Wall Street Journal, and blamed leverage, not derivatives.[7]


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