DERIVATIVES ARE THE KISS OF DEATH
LOS ANGELES (CBS.MW) - 99% of passive investors should never use them.
Was Warren Buffett unreasonable in calling derivatives "financial weapons of mass destruction" and "time bombs?" A Wall Street Journal editorial says yes. Thought Buffett laid this issue to rest with his recent warning about the derivatives in Fortune. But unfortunately, The Journal followed Business Week in defending derivatives and their bizarre world of short-term trading and market timing. It's extremely dangerous to leave Main Street investors with a strong impression the $2 trillion derivatives market has value to average Americans. It doesn't. The high-risk world of derivatives is enemy territory for the vast majority of individual investors, and should be avoided at all costs. Stick with me and I'll show you one more time why derivatives are as big a weapon of mass destruction for a small investor with a $100,000 portfolio as they are in the arena of $100 billion portfolios that Buffett is warning us about.
One derivative "WMD" already exploded.
First, The Journal ignored key facts in hyping derivatives as "one of the major innovations in the financial markets in the past three decades ... The real miracle of derivatives is that they [help] institutions lay off risk, making the financial system less vulnerable to a giant blow-out." Wrong.
The Journal failed to mention that we've already had one "giant blow-out." Remember, Long-Term Capital Management? The global financial system was on the brink of a total meltdown in 1998 when the highly-leveraged LTCM was a huge player in the derivatives game. LTCM, as you may recall, was the brainchild of the two guys who won the 1997 Nobel Prize for their work with derivatives. Unfortunately, their "miraculous innovation" backfired and became the very thing Buffett is warning against, a "financial weapon of mass destruction." The Fed was forced to step in and negotiate a multi-billion dollar bail-out, wiping out LTCM. Buffett warns that today too many derivatives risks are being laid off to an ever smaller group of risk-takers. And that concentration is what is making derivatives a new WMD time bomb.
Business is risky and executives get caught up in the illusion that because derivatives may work on short-term problems, they can also lay off huge long-term risks. That illusion is a booby trap, because most long-term risks can't be identified, let alone effectively laid off.
An illusion for the "little guy"
Unfortunately, a very similar illusion is now being created in the minds of America's 93 million passive investors. Stories in Business Week, The Journal and others are encouraging passive investors to venture into the high-risk gambler's world of derivatives - and all that goes along with them, hedging, leveraging, commodity futures, options, puts, calls, spreads, and other speculative securities more suited high-tech Wall Street pros.
The illusion leads Joe and Jane Lunchbox to believe they too can lay off their risks. That if they just start using derivatives, start timing the market, and get into active day-trading, they will also improve their returns and beat the averages. Ain't gonna happen!
This new wave of articles is also telling us that buy-and-hold doesn't work anymore because we're now in a tricky sideways market with high daily volatility, like we experienced in the 70s and early 90s. They warn that even if you do diversify, you need to do something called "tactical allocation," another word for market timing.
They are basically telling America's passive investors that they only have two choices: You either become an active trader, get familiar with derivatives, start timing the market and buy and sell securities on a daily basis to beat the averages, or resign yourself to low passive returns in the 7-8 percent range, if you're lucky.
Six reasons to steer clear
The suggestion that derivatives, market-timing and active trading are a viable alternative for vast majority of U.S. investor who are passive investors, is absolute nonsense. Switching from passive investing to active trading is not only wrong for the vast majority of investors, it's guaranteed to fail. Derivatives are a "financial weapon of mass destruction" for the small investor as well as the big-time pros. And here's a quick review of the pitfalls:
1. Stock market is irrational and unpredictable
Wharton economist Jeremy Siegel studied 120 big-move days in market history since 1802, and for only 30 was there any rhyme or reason. Seventy-five percent of the time the market is unpredictable. Market-timing is just dumb luck and extremely risky!
2. The more you trade, the less you earn
Behavioral finance professors Terry Odean and Bill Barber of the UC Davis researched 66,400 investors. Two things kill returns for active traders: Lousy stock-picking and transaction costs. Buy-and-hold investors (2% turnover) beat active traders (258% turnover) 18.5 percent to 11.4 percent.
3. Investors "buy-high, sell-low," and lose
Fund investors are bad timers. Morningstar research says they "buy-high, sell-low." Greed creates buying frenzies at the top. Fear creates panic selling at the bottom. Market timing is a costly waste of time.
4. Online trading makes it easier to lose more
Odean and Barber also says investors converting from off-line to online trading saw their returns drop big-time. Before, they were beating the market by 2 percent. After they fell under the market by 3 percent.
5. Too confident: We lose, then deny and lie
Money says 88 percent of investors are too optimistic. In their over-confidence they believed they were beating the market but were actually under-performing by 5-15 percent. They'd make bad decisions, then hide the truth from themselves and others.
6. Even "winning" traders don't win much
Still want to be an active day-trader? The successful ones live, breath, eat and sleep trading. It's an all-consuming full-time job, so you'll have to give up your day job, with its 401(k) and medical benefits. Is it worth it? Successful traders average under $50,000, very few make more than $100,000 a year. It's a lonely life. Many get addicted or burn out. One mistake and you could lose everything in a flash.
Like Buffett says, derivatives really are a "financial weapon of mass destruction," not only for the economy and financial markets, but for the individual investor on Main Street America. They are a time bomb. Run for cover!