Dave Ramsey Lie #5

#5 In Dave Ramsey's Continuing Series Of Lies

This is an excerpt from promotional material attempting to (illegally1) sell people the poor advice of one of Dave Ramsey's "Endorsed Local Providers"

"When Dave says you can expect to make 12% on your investments, he’s using a real number that’s based on the historical average annual return of the S&P 500. The current average annual return from 1926, the year of the S&P’s inception, through 2011 is 11.69%."

Let's take it one lie at a time. First, "He's using a real number that based on the historical average annual return of the S&P500." - True but intentionally deceiving.

This is one of many, many examples of Ramsey using the average person's ignorance against them. The statement itself is true. The deception comes in his use of the words "Average Annual Return". 
Knowledgeable financial professionals know the term is meaningless, and they know what Dave really means, but can't say, is "Compound Annual Growth Rate"


Let's look at it more closely;

"Annual Return" is, well, the annual return. If you begin the year with $100, and at the end of the year you have $110, you annual return is 10%. Simple? Yes. 

January 1       - $100
December 31 - $110
Return (or increase) - $10  *There can't be an "Average Annual Return", since there is only one year


Now, suppose at the end of the second year, you lose money and you end the year with $100 again. 

January 1       - $100
December 31 - $100
Return (or increase) - $0 

What is your total return for the 2 year period? 

ZERO. 

You started with $100 and at the end of two years you have $100. Your return is ZERO.
Every literate person can understand this.

But....

According to Dave "Liar" Ramsey, you made 5%.

He says your year 1 return was 10%. Your year 2 return was 0%.

10+0= 10 

divided by the number of years (2),

10/2 = 5

And viola! you have a "Average Annual Return" of 5%. 

Where is this $5 Dave? 

The Truth

Dave Ramsey is intentionally substituting the meaningless term 'Annual Average Return' for Compound Annual Growth Rate (CAGR). 

The CAGR is the number legitimate Financial Advisers use, and, with accurate informational input, can give you realistic numbers to use in making major life planning decisions. 

Ramsey knows when he says 'Average Annual Return', most people will think 'Compound Annual Growth Rate', even though they don't know the term. "They will think Dave Ramsey said I can expect to gain 12% per year, every year."  


Addendum

The Compound Annual Growth Rate of the Standard and Poor's 500 Index for the period 1929 to 2011 is actually 2.43%2, a huge difference from Dave's 12% Lie, and the real-world difference between a comfortable retirement and abject poverty. 




1- Securities Law, including the Securities Exchange Act of 1934, make it illegal to profit from the sale of securities unless one is licensed. Dave Ramsey is not a licensed securities professional, but receives "kickbacks" from members of his ELP scam

2- Adjusted for Inflation

Corporations vs Charters

The history of constitutional law is the history of the impact of the modern

corporation upon the American scene.

-    -  Supreme Court Justice Felix Frankfurter

Individuals are legally required to support corporations’ political advertising. Opposition is a violation of the corporation’s First Amendment rights. [1]

EPA monitoring of the air over a corporation’s factory, constitutes violation of the corporations Fourth Amendment rights. [2]

Corporations must be compensated for compliance to environmental regulations. Lack of compensation violates the corporation’s Fifth Amendment rights.[3]

Yes, inanimate, non-accountable corporate entities have the very same rights[4] afforded you by the authors of the Constitution. But it wasn’t always so. The Constitution doesn’t mention corporations. In Colonial times, corporations as we know them today didn’t even exist. Instead, there were charters*. The Founders knew well the abuses of the contemporary charters such as the East India Company, the Hudson's Bay Company and the British Crown charters in America and chose to allow the States to regulate them.

*Technically corporations are charters. For the purposes of this post, “charter” is used to identify the original charter entity before the re-definition of the word in the 19^th century.

Some key differences between corporations and charters;

Charters	Corporations
Of limited duration, Must be renewed or disbanded.[5]	Perpetual
Capital is limited	Capital unlimited. Can be "too big to fail"
Established for defined reason	Essentially unlimited
Strong accountability to shareholders is written into charter	Weak accountability to shareholders.
Minority shareholders protected	Minority shareholder support not needed for major decisions
All stakeholders responsible	Stakeholders not responsible for corporate actions

As early as 1816 Thomas Jefferson, always a foe of large powerful entities, warned of the threat to the young democracy from “moneyed corporations”;

“"I hope we shall …crush in its birth the aristocracy of our moneyed corporations, which dare already to challenge our government to a trial of strength and bid defiance to the laws of our country."
- Thomas Jefferson, Letter to George Logan, 1816”

It took 70 years of struggle, but the corporations won their “trial of strength” in the infamous landmark Supreme Court review of Santa Clara County v. Southern Pacific Railroad, 1886; which overturned previous precedent and was used to give corporations the legal status of a natural person, and thus by extension, protection under the Bill of Rights. (Before this time corporations were considered “artificial persons” with a limited sub-set of human rights).  Since then, corporations have won erroneous judgements one after another, until we have arrived at the sorry state we find ourselves now.

Supreme Court Justice William 0. Douglas commented on the decision decades later, writing;

"There was no history, logic or reason given to support that view"

Corporations are Accountable to No One

Not the Government;

We regularly see in the news headlines “Corporation X Fined XX Dollars”. This is misleading. Corporations no longer exist as a privilege granted by the people through their government, but rather they exist under “contract” with the government. This is the reason fine amounts are “recommended” and companies are allowed to negotiate the final value. Corporations are not “fined” in the sense that you are fined for speeding or jaywalking, but rather the “fines” are more akin to liquidated damages for a violation of their “contract” with the government.

Directors can be held liable only for their own personal misconduct. No single person or persons are accountable for miss-deeds of the corporation.[6]

Not the People;

Corporations, having usurped the Commerce Clause to relieve “themselves” of government authority, and gained protections under the Bill of Rights, have granted “themselves” much greater freedoms than enjoyed by any individual. Individuals cannot invoke Commerce Clause precedent to overrule laws. Corporation can, and do on a regular basis. This has created the curious situation where an entity (the corporation) is no longer accountable to the entity that created it (the government). 

Even the most die-hard free-marketer must admit that even if individuals and corporations should have equal rights, it is much more difficult for the individual to assert those rights. Do you have a personal lobbyist in Washington? (No, your congressional representative doesn’t work for your interests. They follow corporate wishes and interests; you are not going to give them a job when they leave government).

Not Shareholders

Shareholders routinely resort to litigation to assert their supposed rights to control the corporation. Minority shareholders are easy silenced by majority shareholders or shareholder blocs. Shareholders have no direct influence in matters such as treatment of workers or the environment.

Not the Consumer

Even if corporations are not accountable to any one else, they must be accountable to the consumer, right? Not really. Corporations can treat consumers any way they chose. Telephone companies are one example. They routinely mistreat their customers, their business declines, and then they merge or otherwise reform themselves under a different name and continue business with the same equipment, the same employees and even the same customers (Who are non the wiser) Study the history of ATT for proof.  Airlines are another striking example. Under a charter system, entities that harmed the public good would be disbanded and their assets sold and delivered in proportion to their stakeholders.

Corporations (including the Federal Reserve) are the scourge of democracy and will be the cause of the failure of the Grand Experiment.  You cannot “vote with your dollars” to force corporations to behave in an ethical manner. The only hope is to reform the nature of corporate “personhood” and return to the ideals of the founders of this great country.

[1] Pacific Gas & Electric Co. v. Public Utilities Commission of California ET AL. Appeal from the Supreme Court of California. No. 84-1044.

[2]  Dow Chemical Corporation v. U.S., 476 U.S. 337

[3] U.S. Supreme Court review of Pennsylvania Coal Co. v. Mahon 260 U.S. 393 (1922)

260 U.S. 393 Pennsylvania Coal Co. v. Mahon et al. No. 549.

[4] Actually, they have more. An individual’s power to control government is through the vote and the resultant composition of Congress and the Presidency, and ultimately, through elected officials, the Judiciary. But since corporations have successfully hijacked the Commerce Clause to limit government’s power, they are ultimately accountable to no one.

[5] The scourges of the First and Second Banks of the United States were eliminated by allowing the charters of these abominations to expire. The present incarnation of this evil, The Federal Reserve, cannot be dispatched so easily because its status as a corporation allows it to exist in perpetuity.

[6] To cite a recent example, is the CEO of British Petroleum responsible for the Gulf disaster? No, he wasn’t even there, he had no way to know what they were doing, and he can’t be expected to keep up with every employees actions. How about the guy on the

 

rig? No, he was just an employee doing a job. He can’t be responsible for the corporation. Inevitably, a mid-manager will be taken to task for the disaster and punished accordingly. But does this change the corporate attitude? Can this alter the corporation’s way of doing business? Of course not. In the end, no one is accountable. What incentive does BP really have to be responsible? If worse comes to worse, they can always simply merge with some unknown company, change their name, and continue business as usual. BP can easily change their legal structure, since there is no longer a requirement to serve a public good. Articles of Incorporation are available simply for some relatively trivial paperwork and fees. Would the boycotters even know? No, they would declare “victory”. Would anyone even care that the new ACME Oil company was formerly BP? No, they will have moved on to the next cause. BP knows this.

Federal Reserve's Exit Strategy and What It Means for the Stock Market

"Federal Reserve officials have mapped out a strategy for winding down an unprecedented $85 billion-a-month bond-buying program meant to spur the economy – an effort to preserve flexibility and manage highly unpredictable market expectations."

What does this mean? Why would the Federal Reserve reveal that they have "mapped a strategy" to stop their bond-buying binge?

First, the "what does it mean" question - nothing. It means nothing. No one expects the Fed to take any action in the immediate future.

The answer to the second question is more revealing; the Federal Reserve knows their policies have come to have a direct effect on the equity markets. This "leaked" bit of information was designed to gauge the reaction of the stock market to the inevitable end of the bond- buying program. The last thing they want is an overshoot to the downside in the market, so they are conducting research into possible actions to take. 

The great unknown is the effects of the ongoing currency war. The devaluation of the Yen makes the Fed's job infinitely more difficult by strengthening the dollar. It has also put immense pressure on the Eurogroup to act also.1

What to do?

I've been giving the warning that the current rise in the stock market is artificial and unsustainable. If you refuse to take my word for it, perhaps you would be interested in Bank of America's recently released strategy;

 1. Slow down of asset purchases

2. Slow down and then stop reinvestments

3. Raise short-term rates

4. Begin sell down of asset portfolios

1. I plan to do an article about the currency wars soon. The vast majority of people could care less about the price of money in Japan, but they should be very, very concerned, as it will have a profound effect on everyone.

Inflation Drifts Below Target - Why This Isn't Good News

The Treasury and Federal Reserve have been reporting that the inflation rate is "running somewhat below" their target rate of 2.0%. n the latest Board meeting, the decision was made to continue the current policy of buying $85 billion a month in bonds, and there is speculation this amount may be raised. 

So, is "inflation below target a good thing? In short, no. First, let me point out that the "inflation rate" they are talking about isn't the same one you think you are familiar with. The Federal Reserve uses the  Personal Consumption Expenditures (PCE) price index. The rest of the country uses various flavors of the Consumer Price Index (CPI). The CPI is near worthless for the evaluation of everyday prices and the PCE is even worse. By the way, the real rate of inflation, using the pre-1980 methodology, is running almost 10%.

There are two factors that make the current situation dangerous. First, the Fed's purchase of massive quantities of bonds is artificially driving money into other investments such as equities. This is the primary reason for the recent rises in the stock market. It's not an economic recovery. It's a bubble. Secondly, the 4.4 trillion dollars the Fed has already "printed" is a significant inflationary pressure. Every month the Fed buys up more bonds raises the water level behind the inflation dam. Right now, the 4.4 trillion, and the tens of trillions held by foreign banks, and the tens of trillions converted to Eurodollars are not accounted for in the inflation equation. When the bond market collapses, these factors will come into play rapidly.

If you are in the stock market (most people are, either directly or indirectly through pension plans, etc) be aware that conventional advisers such as Dave Ramsey are lying to you when they say the stock market is a great long term investment strategy. It isn't. The history proves it. And right now is the most dangerous time to be in the market since 1928. Be ready to move quickly.

Hyperinflation Warning - The Eurodollar Menace

The existence of the Euro-dollar market increases the total amount of dollar balances

available to be held by nonbanks throughout the world for any given amount of money (currency plus deposits at Federal Reserve Banks) created by the Federal Reserve System. It does so by permitting a greater pyramiding on this base by the use of deposits at U.S. banks as prudential reserves for Euro-dollar deposits.

- Milton Friedman, Selected Papers, No. 34

Not to be confused with the Euro currency, the monetary unit of the Eurogroup, a Eurodollar is;

"U.S.-dollar denominated deposits at foreign banks or foreign branches of American banks. By locating outside of the United States, eurodollars escape regulation by the Federal Reserve Board."[1]

I present a simplistic scenario to explain the effects and dangers of the Eurodollar:

Suppose a country creates a currency as a medium of exchange. Let’s say they start with 1 million units. If they then create 1 million more units, it is reasonable to assume the value of each unit, both the existing ones and the new ones, are decreased by half. (The reciprocal of the total number of units). This is classic monetary inflation.

Original unit value = 1

Unit value after doubling the number of units = 0.5

Unit value after quadrupling the number of units = 0.25

…etc

Now suppose that the number of units is doubled, but all the new units “disappear”

Original number of units = 1 million

New units created = 1 million

Total number of units = 2 million

1 million units “disappear” – 1 million

Number of units in circulation = Still 1 million

Therefore, each unit value is still = 1, because the newly created units disappear and don’t have an effect on the value of the original units

This is what happens when U.S. dollars are created by the Federal Reserve and get converted to Eurodollars. Because of the U.S. dollar’s status as the world's reserve currency, other nations must convert (buy) U.S. dollars to conduct international trade. Some of these dollars are kept overseas and never return to the U.S. Just like in our example, they disappear.

This is a great deal for the U.S because it means it get goods essentially for free. As a nation, the U.S. can print dollars and trade them for imported goods. Because the dollars don’t come back, they do not cause inflation. It’s a free ride the country has been on since the end of the Second World War. This is the basis of America’s wealth. Not innovation, not the American work ethic; Trickery.

But in the end, the trick is on the U.S. All those Eurodollars didn’t really disappear. They are still out there. When the rest of the world decides to adopt a new reserve currency, a process that is well under way, they will no longer have a need for the 9.7 trillion dollars they now hold. The dollars will come flooding back into the U.S., inflation will quickly degenerate into hyper-inflation and the real losers will be those required to own dollars – the American taxpayer.

Are you prepared?

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[1] http://www.investopedia.com/terms/e/eurodollar.asp

What's Behind the Gold Price Plunge?

Since my time at REFCO (yes, that REFCO) I have maintained that gold is the most manipulated market in the world, behind fiat currencies of course. But what is going on with the dramatic price moves in gold lately?

First we need to examine what initiated the sell-off. It wasn't some world event or major development; the price move started after brokerage houses and Goldman Sachs notified private investors of an impending liquidation of gold by some large hedge funds. Has this happened? Not yet, and it probably won't.

Most of the price pressure has come from uncovered short futures positions. This isn't unusual in itself, considering the technical status and alleged overbought condition of the market. But we need to look at the bigger picture to get a clear understanding...

The Japanese have embarked on a qualitative easing campaign and the Federal Reserve is pressuring the Euro Zone to do the same. The answer to why, of course, is to prevent an uncontrolled crash of the Dollar because of the massive qualitative easing done by the Fed themselves in the past few years. There is an incredible amount of dollars out there that potentially represent a tremendous inflationary pressure. While the Federal Reserve tells their deflationary fairy tale on the one hand[1], on the other they are desperate to control the dollar. Gold presents a clear and present danger to the Fed's plan and so it is entirely likely they instructed Goldman Sachs and others to deflate gold.- Keep in mind, Goldman Sachs and the rest of the investment and fund houses will win no matter what. They are partners in crime with the Federal Reserve.

My advice -  I am not a "gold-bug" by any means. But ANY hard asset is better than dollars. If you have physical gold, hang on to it. Buy some if you have some extra funds, but don't tie up all your investment in it. The effort to prop up the dollar may get very ugly and gold volatility may go insane. If you have derivatives of any kind, and especially gold derivatives, you are gambling with your wealth. You might as well be at the casino.

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[1] In a recent blog post, Gold Does Not Glitter, Paul Krugman tries to make the case that the gold price drop is proof there is no inflation danger.

Hyperinflation Warning - Debt Phase Transition

The Federal Reserve has been “printing money” on a massive scale for the last several years in support of various stimulus programs; a process they now call Quantitive Easing, or QE. Keynesian theory allows that spending, even deficit spending, results in economic growth. And this has actually been the case during various periods in the 20^th century. For example, increased spending during World War II resulted in a post-war economic boom. Keynesian theory supporters can point to several other examples. 
However, according to the Federal Reserve; 

"QE did not dramatically increase bank loans and the growth of broader monetary 
aggregates." 

What makes the current situation different? -  Economic growth is dependent on the utility of debt.

Let us consider the famous Widget Company. Say the Widget Company manufactures 100 widgets a day. They can take out a loan to buy additional or better equipment to increase their output to 500 widgets a day. Obviously then, the ability of the company to borrow money has some utility. If every dollar borrowed enables the company to earn more than a dollar, the Utility of Debt is said to be greater than 1.

Extrapolated to the entire economy, the same general principle applies. Historically every dollar created by the Federal Reserve has resulted in more than one dollar in increased economic activity. But there is a limit. Eventually a point is reached where the new dollar creates less than one dollar in new economic activity. This point was reached somewhere in the 1950’s. 

Debt Phase Transition is the term applied when the creation of a new dollar actually causes a contraction of economic activity. We have recently reached that point. We have reached a point of debt saturation. No amount of money creation (money printing) can cause economic recovery. Furthermore, the increase in money supply only makes the problem worse since each new dollar actually decreases activity. 

The only possible solution is the reduction of debt, and this can happen in only three possible ways – 1.) Repay the debt, 2.) Default the debt, and 3.) Erase the debt through hyperinflation.

It should be obvious that neither of the first two possibilities will ever happen. (If you do not agree, please see upcoming posts for proof.)

This leaves only hyperinflation. The massive amounts of money being put into the system has not caused inflation yet because it isn’t being used. Money Velocity is very low. (See chart below). But this money still exists, along with huge amounts that has been transferred out of the country because of our multi-decade trade imbalance. All of these excess dollars constitute a large reservoir that will flood the economy when the holders of these dollars decide to exchange them for something else – a process that has already begun.

At no time in the history of man and money has there been such a buildup of excess currency. The hyperinflation that must result will be unprecedented and will make previous hyperinflation events seem insignificant.

Economics Is NOT Rocket Science - Stages of the Economic Cycle

This blog was created to simplify the alchemy of economics. Economics is not rocket science, . I maintain that it isn't even a science at all. Behind the facade of formulas, theories and schools, the underlying principals are relatively simple. 

The issue is separating economics from business and investing. Both are essentially the study of people. In economics, if people do a, the result is x. If they do b, the result is y, and so on. The problem in business and investing is trying to predict if and when people will do a or b. Of course, this can be impossible, and is the reason business and investing is difficult....and complex. 

In economics there are "laws" or "rules". Economics doesn't follow the Austrian School some of the time and the Chicago School some of the time. This is ludicrous, despite the fact there is a huge industry of producing and employing economists and researchers. The Federal Reserve itself employs over 300 PhD level professionals. 

So in the interest of offering people a clear view into the obfuscated world of economics, I am re-posting an article from a couple of years ago outlining the true stages of the economic cycle. This cycle has been repeated over and over throughout the history of mankind, and despite of, or perhaps because of, our technical progress we are still subject to the same cycle. Because we are now in stage 11, it is important to know the truth.

True Stages of the Economic Cycle 

1. Hard Money. A form of currency is established to facilitate commerce. In order to gain acceptance the currency is backed by something of intrinsic value such as precious metals. This is known as Hard Money.

2. Debasement of the Currency. It is immediately evident that “free” wealth can be created by Debasing the Currency. In its most fundamental form this involves the practice of charging interest (or usury, the meaning has been exactly the same throughout history up until recent times).

3. Enactment of Legal Tender Laws. Without Legal Tender laws, implied values are self correcting and always closely match true value. Legal Tender laws greatly facilitate the debasement of a currency. The Founding Fathers knew this, Thomas Jefferson wrote: 

"If the American people ever allow private banks to control the issue of currency, first by inflation, then by deflation, the banks and corporations that will grow up around them will deprive the people of all property until their children will wake up homeless on the continent their fathers conquered".
 

The U.S. Constitution, Art. I Sec. 10 Cl. 1, states: 

"No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts;"

The Supreme Court ruled in U.S. Supreme Court - Wheaton 1827; 

“The prohibition in the constitution to make anything but gold or silver coin a tender in payment of debts is express and universal. The framers of the constitution regarded it as an evil to be repelled without modification; they have, therefore, left nothing to be inferred or deduced from construction on this subject.”

4. The Accumulation of Debt is unavoidable with legal tender laws in general, and especially in a Central Banking scheme such as our current Federal Reserve, in which the perpetual increase of debt is an essential component.

5. An Illusion of Economic Prosperity is created by the accumulation of debt. This is no different in principle from a person going on a spending spree with credit cards. They have the illusion of being very prosperous, but in reality they are destined for a reckoning when the debt cannot be paid.

6. Monetization of the Debt. As the accumulation of debt becomes unmanageable, it become necessary to monetize the debt. The debt grows so large it cannot possibly be paid. There are a few ways to “resolve” this. 

• The most obvious way is through taxation, but this is never politically acceptable. 

• Another way is by directly devaluing the currency. This has been done many times in history, but is also not very politically acceptable.
• The third, and easiest (for leaders at least) is hyper-inflation. In simple terms hyper inflation erases debt by transferring wealth from individuals to government.

It is apparent that all three solutions have one thing in common – all transfer wealth from individuals to government, or more accurately, to the central banks.

7. Dilution of Currency Value The process of monetization directly causes a Dilution of Currency Value.

8. Loss of Confidence. In essence Consumer Confidence is a measure of how well the taxpayer is being fooled into thinking all is well. The dilution of his buying power caused by the dilution of currency creates a Loss of Confidence.

9. Inflation. As buying power decreases, the consumer tries to make up the difference by charging more. The merchant charges more for his goods, the laborer demands more for his services. This is classic Inflation.

10. Inflation Stabilizes as government  implements inflation control measures, but does nothing about the underlying problems, causing a:

11. Return of Inflation, quickly followed by:

12. Hyper-Inflation, which effectively erases the debt. If the U.S. experiences the level of hyper-inflation similar to Hungary in 1946/7 (42 QUADRILLION percent per month), the entire national debt could be paid off with less than a penny. This may sound like a good thing to some, but the truth is, wealth is simply transferred from private individuals to the government. This is the stage of Reckoning. It is obvious that there was no real wealth created in phase 2. This is the essence of my argument against the “Economy creates wealth” proponents. Economic trickery does not create wealth. It never has and it never will.

The wealth transfer causes:

13. Depression, which leads to:

14. Reorganization of Government. It is only at this point that a significant number of people understand the inextricable link between wealth and real money. This enlightenment leads to:

15. Return to Hard Money, and the cycle repeats.

These phases are exponential in nature. The time from the debasement of a nations’ currency to the loss of confidence in that currency can be measured in decades or even centuries. The time between the loss of confidence and inflation however, may only be weeks or months. In the later stages of hyper-inflation the loss of a currency’s value and the accompanying price increases can double in days or even hours.[1]

It should also be noted that inflation is not bad for everyone in equal measure. It is actually a good thing for those people of means who are in a position to borrow to purchase property. The reason is the same; the repayment of debts, is made in currency that is worth less than the currency originally borrowed. This is also the reason working people cannot prosper during times of inflation or hyper-inflation. Wages are generally not indexed to inflation and always lag price increases. Even in the case of the relatively few people whose wages are indexed to inflation, the adjustment is always done after the fact. Loses accumulated from the previous adjustment are never recovered.

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[1] In the Weimar Republic in 1923 workers demanded, and were paid three times a day in order to be able spend the money before it lost further value. 

The Misapplication of Gaussian Math in the Financial Sector

Business is about mathematics. Macro-economics is not, it is about people and reality. This is a fundamental flaw in economic thinking. And one that causes economic disasters one after another.

This is the formula for the Gaussian Distribution, better known as the “bell curve”. Most financial model up until very recently used this model. Many still do. It is used in the ubiquitous Black-Scholes option pricing model. 

However, because it is a Gaussian distribution, it does not properly account for risk (events) outside of 5σ, therefore pricing for far-out-of-the-money options are mis-priced.

In 2000, David Li published his “Li’s Function”, a type of Gaussian copula function.

Pr – Probability.. as in default. This is the variable that is solved for. In other words, The rest of the equation gives the answer for Pr
T – Time between now and when default is expected.
= - Equality used to eliminate uncertainty
F – Probability of survival 
Φ – Used to sum the probabilities of A and B 
γ – Used to reduce correlation.

Li’s Function was quickly adapted for use in pricing Collateralized Debt Obligations (CDOs) because it allowed investors to quantify risk. Unfortunately, it suffered from the same type of flaw as the Gaussian Distribution – it failed to account for unlikely events1.

Whatever other factors involved in the financial meltdown of 2008, the use of this formula was the singular major cause of investor losses. Because it failed to assign proper risk values, the actual risks were far greater than expected.

Even after the fiasco of 2008, modified versions of Li’s Function and other Gaussian Copula functions are still being used in financial circles to price multi-instrument products such as currency swaps.

Economists and financial advisers are still attempting to modify Gaussian mathematics and Game Theory to fit economic reality. But all attempts suffer the same weakness. 

It is impossible to account for all possibilities since the bounds of all possible things that could happen are infinite. 

This isn’t the case with Game Theory. The roll of a roulette Wheel or the deal of a card hand may be random, but they are bounded. There are a known number of slots on the roulette wheel, and a known number of possible card hands. The bounds of possibility in the real world, and by implication the financial world, are infinite and unknown. We do not know what possibly can happen to affect financial markets in the future. Therefore, if no one knows, how can risk be calculated? It can’t. And so the next big financial catastrophe is just around the corner.

Mainstream financial “gurus” (like Dave Ramsey and most financial advisers) mislead their clients by not taking into account the huge losses that happen regularly, but are not predicted or accounted for in their models. The fact that a lot of retirement accounts and other wealth were wiped out in 2008-12 is NOT unusual or dramatic. It is guaranteed to happen. Putting money into non-cash, non-good based instruments is reckless; no difference in essence than gambling.


Business is about mathematics. Macro-economics is not, it is about people and reality.



1. In fairness to Mr. Li, his function was theoretical, and may have never meant to be applied to real-world trades. We do not know, since Mr. Li returned to his native China and refuses to discuss the matter.