So I finished “A Random Walk Down Wall Street.” I am quite appreciative of this book. Yet I admit it surprises me a little bit that the father of the index fund has a forty-page appendix devoted to derivatives. Especially after reading Malkiel’s explanation, derivatives strike me as excessively risky to the point of being dangerous, or at the very least, highly problematic for the average investor. I wonder if working with derivatives is even consistent with the philosophy of buy-and-hold, long-term index fund investing.
Admittedly I have no actual experience with these financial instruments. I’m trying to stay open. Let’s start by laying out what derivatives are. Malkiel writes,
A futures, or forward, contract involves the obligation to purchase (or deliver) a specified commodity (or financial instrument) at a specified price at some specific future period.”p. 421
Derivatives are financial agreements based on the expected future value of assets.I understand how this would help farmers, for instance, know how much they will be making from their crop, so they can plan their expenses accordingly. Making a deal about the price of wheat, to be delivered in the future, has a practical sense to it:
Despite their association in the financial press with speculation and gambling, futures markets have a valuable economic role. They permit both producers and consumers to transfer risks in such a way that all market participants can be better off.p. 423
When you move from futures on commodities to futures on financial instruments, the jury’s still out as far as I’m concerned. Options, for instance, appear to be short-term bets on what a stock/asset will do next. Will it go up? Will it go down? Place your bets! The reason options are popular seems to stem from the fact that, for a fraction of the price of the asset in question, perhaps only 10%, you can acquire buying or selling rights to those assets. If you are right, your bet can profit you handsomely. As Malkiel writes,
[F]utures markets allows you to control billions of dollars worth of securities while putting up a security deposit of only millions. Derivatives truly provide investors with staggering amounts of leverage.p. 434
And that is exactly where the trouble starts. The danger of options is that your bet doesn’t go your way. And how likely is it that everything will go your way?
The possibility that an ordinary investor can take a sum as small as $1,000 and, by shrewd trading, turn it into $100,000 in a few months [with options] is about as likely as going to Las Vegas, putting a dollar in a slot machine, winning the $50 million grand prize, and then walking away, never to enter a casino again.p. 433
Indeed, many big, seemingly-smart companies have been burned at the hands of derivatives:
During the mid-1990s, Proctor and Gamble entered into a customized derivative transaction it thought would achieve its borrowing objectives. It turned out that the company lost over $100 million when Germans U.S. interest rates both rose sharply….Orange County, California, announced that its Christmas greeting in 1994 was to file for bankruptcy protection after taking a $2 billion loss in risky investments. While derivatives played only a part in the Orange County debacle, they came in for the most criticism in the media. At the end of February 1995, one of Britain’s most venerable banks, Barings PLC–the oldest investment firm in the U.K.–collapsed after suffering more than $1 billion loss from trading Japanese stock-index futures contracts.p. 433
Then there was the little matter of the 2008 Financial crisis:
Warren Buffett, arguably the world’s greatest investor over a forty-year period well into the 2000s, has called derivates “weapons of mass destruction.” There can be little doubt of the correctness of that statement when one examines the 2007-08 period, when derivatives threatened to bring down the entire financial system…. the enormous leverage associated with derivate contracts on mortgage-backed securities led to a near-collapse of the banking system that was averted only by a government bailout of leading financial firms such as Citigroup, Bank of America, and Goldman Sachs.p.434
I admit that, having lived through the Financial Crisis, I could be biased against the financial instrument that apparently caused it to happen. Given the damage that derivatives have done, one wonders why anyone would ever want to use derivatives at all. The answer, of course, is the possibility of winning big from making a bet that turns out to be correct. . Let’s say you correctly guess that the price of a stock will double. You are able to purchase the stock at $50 when it goes up to $100 because of the options you bought on that stock. You then sell those shares for double what you paid for them. Your profit then becomes double what you paid minus the costs of the options themselves.*
I can see the appeal of this. Yet as I was reading about options, I thought, “Wow, these kind of profits really do change the flavor of this activity. It really becomes less like investing and more like gambling.”
In other words, among other dangers I see the very real possibility of being blinded by greed. Greed is a strong emotion that can mess with our judgment. The possibility of winning big with derivatives is countered with the (more likely?) possibility of losing big:
When you buy a $100,000 position in Treasury bonds for future delivery, you may have to put up an initial margin of as little as $1,000. But if the Treasury securities suddenly drop in price by just 2 percent, a movement that could happen in a single day, you will be liable for a loss of $2,000, double the amount of your initial capital. This explains how some traders can suffer extraordinary losses even if they put up relatively small amounts of money.p. 433
Conclusion? I think I will stick with my index funds.
But it’s still interesting to learn something new.
*This example is only valid if I understand options correctly. Which I don’t pretend to.