11 October 2012

Derivatives, the Devil and the Holy Water

Most private - even if sophisticated - investors will have never heard of Warren Buffett's famous dictum where he described derivatives as 'financial weapons of mass destruction'. We always have advised readers and clients to give derivatives (including 'structured' or 'guaranteed' products) a wide berth. Most investors - including Yours Truly, do not have the capability to look behind the complicated financial mathematics that is required to properly understand these concoctions. Neither do we have the slightest desire as it would be a futile exercise. If properly priced these instruments basically are a chip to participate in a financial bet that is a zero sum game. And half the participants are by definition destined to loose. We leave it up to the imagination of the reader to guess on which side a part-time investor will find himself when he pits his wits against highly motivated (because highly paid) financial engineers who do nothing else but design 'products' that allow them to profit from the losses of the other party to the bet. A particularly drastic illustration is provided by the latest revelation of the popular game played by blue chip (and lesser) financial institutions called heads I win, tails you loose. Does a storied bank with a reputation to loose really need to sell a 'variable prepaid forward' to an unsophisticated lady? The lesson is clear: ordinary private investors should stay clear of derivatives like the devil from the holy water!