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Beware the Siren Song of Derivatives...

| November 22, 2017
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The masses do not see the Sirens. They do not hear songs in the air. Blind, deaf, stooping, they pull at their oars in the hold of the earth. But the more select, the captains, harken to a Siren within them... and royally squander their lives with her.

Nikos Kazantzakis

It’s Greek to me…

In Homer’s Odyssey, Odysseus was warned about the Sirens he would encounter while sailing home. The Siren Songs would seduce him and his sailors into crashing their ship. To avoid their demise, Odysseus had his sailors put wax into their ears as they rowed. Odysseus wanted to hear the Siren Songs and had his men tie him to the mast of his ship as they sailed past the Sirens.

Our money ship and financial derivative products…

We are all captains of our “money ship” constantly being tempted by the Sirens with their Songs. It seems that the Sirens are singing as I have been getting a lot of questions on financial derivative products that will protect their investments from an “imminent” market collapse.

First, let’s delve into derivatives and credit risk…

Financial engineers (meant to project precision when nothing is imminent) create complex/expensive financial products for a specific purpose using financial derivatives (a contract between two or more speculators, where the value of the contract is based/derived from the underlining asset such as a stock’s price). Your home insurance policy is a simple version of a derivative, where the insurance company will compensate you for the value of your home should it get destroyed. The homeowner pays annual premiums/fees to the insurance company and the insurance company pays the homeowner to replace his house (inflation adjusted) should it get destroyed.

There is a credit risk for the homeowner if the insurance company doesn’t have the money to pay. This inability to pay is the major reason for runs on banks, where depositors descend on banks to withdraw all their deposits for fear that the banks can NOT pay them back their money. Runs on banks led to the creation for the Federal Deposit Insurance Corporation (FDIC) in 1933. There is NO FDIC insurance on derivatives, so there is a credit risk that the issuer of the derivative can’t pay.

Binary outcomes…

Financially engineered derivatives are manufactured for speculators that want to bet whether a price of something goes up or goes down beyond a specific level…so the outcomes are binary, higher or lower than a certain price by a specific time. Contrary to speculating on a binary outcome, you invest for a goal to reach an income level and/or wealth level to be able to retire and maintain a desired lifestyle; the more you save and invest, the more you will be able to achieve your goal. So speculating with derivatives for a binary outcome and investing for a goal are very different.

The sirens are singing that the equity markets are due for an imminent collapse…

First, we know nothing is sure to happen. Since the financial crisis, “experts” have predicted many times the imminent collapse of the global economies and financial markets due to a global debt default crisis. Within 5 hours of results to see if the British would vote to “Remain” or “Exit” the European Union, “bookies” or “betting markets” (yes all the major financial firms used these speculative terms) predicted that there was an 88% chance that the “Remain” vote would win. The New York Times on November 8, 2016 gave Hilary Clinton an 85% of winning the Presidential Election and only a 15% chance for Donald Trump to win. As we can see, nothing is imminent. We also can see that all this speculation has nothing to do with achieving your investment goals as the markets shrug off the “breaking news” and moved higher based on rising global economic and corporate profit growth.

Raise cash if you can’t sleep…

As financial derivative products are expensive to deploy and if you are losing sleep worrying about a market collapse, a cheap fix is to raise cash in your portfolio. I usually recommend between 10% to 20% in cash because if the market doesn’t collapse, you are still 80% to 90% invested toward your financial goals.

If you are not sleeping well because you are worried about the markets collapsing, you should call your portfolio manager and/or relationship manager to discuss the matter. We are here to help and not sell you expensive derivative products.

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