Just because you don't understand it, it doesn't mean it's not useful to meet financial goals

                     Last week I found myself getting into two interesting and contrasting conversations over dinner about particular investments. A friend of mine was discussing with me his taste for trading stocks and ETFs on a weekly basis, effectively trying to time the market and get in and out of stocks from what he says was based entirely on analysts commentary and predictions. Now I've been pretty vocal on my thoughts of the folly of trying to trade on a short term basis by timing the ups and downs of the markets and individual stocks and I relayed this to him. He was very insistent so I suggested to him that if he wanted to predict on short term movements he should consider investing in an ETF on the VIX (An index often used as a proxy for future short term volatility of the S&P 500) in the lead up to the next US budget and debt ceiling issues and then sell just before deadline (after all we're likely to have another deja vu budget debacle!). I said to him this was probably more predictable and likely to give a higher short term return than any of his stock equivalents. (As way of example, investing in VIXY:US over the last budget crisis period could have netted a 20% return in 3 weeks). He however wasn't to be moved, telling me that whilst he didn't quite understand the product, investing in this type of index was pure gambling as opposed to his stock bets.

               It did get me thinking though that often we look at financial products we don't understand and think of them as purely speculative (or gambling) tools. It is understandable that after the effects of the last financial crisis many look at derivatives as just another invented way to make money. Warren Buffet has famously called them "financial weapons of mass destruction". But as with most of what we now perceive as being an investment class, the majority of derivatives were not created for the pure purpose of speculation. 

Derivatives weren't always purely speculative

               The first traded derivative contracts were futures on a variety of commodities. The idea was that farmers growing corn, for example, would be able to know exactly what price they would get for the corn they were delivering in March, as oppose to being faced with a lower price than expected if they were just to sell it on delivery. It provided a contract with a predetermined price which gave more financial certainty to both the buyer and the seller of the corn. Options also evolved as a form of insurance contract. Like a house insurance contract where you might be worried about losing value because of a fire in your home, a person who holds a stock, might purchase a put option to protect themselves should the stock price fall below a certain level over a certain timeframe. 

             I think it's fair to say that most derivatives began life this way, offering it's purchasers some form of security against an asset which they held. The aforementioned VIX futures were seen as a way for traders in US markets to protect themselves against market volatility, the idea being that when markets fall extensively is usually when they are at their most volatile. By holding a contract which makes money when markets become more volatile, you are giving yourself some protection when your stock holdings might be in freefall in a downturn. The Credit Default Swap (CDS), which is now a several hundred trillion dollar market, came about as a way for bondholders or loan issuers to insure themselves against the risk of default by those they had lent to. Even the more structured products often came about as a means of offering protection to holders of the underlyings, albeit by ever more complicated methods. Of course where one person seeks a means of protection for unwanted risks, there are many others who see this as an opportunity for speculation and financial gain. Hence why these markets, once started, often get out of hand and end up as another method for investors, individual and institutional, to ever increase their wealth (or decrease when the going gets tough!). The notional value of CDSs out there often outweighs the notional value of the bonds and loans upon which they provide insurance as speculators use it as a means to both receive premiums or hope for payoff through the survival or downfall of any number of corporates or countries. 

Are Derivatives really any different from other Asset Classes?

               If we're honest though, is this really any different from what we'd consider investing or speculating on other asset classes which we consider normal? After all, a house or a flat, for most of us, is a place for us to live, something which we all need. Somewhere at some point, someone realised that they could purchase many properties and charge other people to live in them because everyone needs a place to live so is willing to pay for that privilege. Yes bricks and mortar leaves you with something physical, but the reason for investing is just the same and carries risks of its own. I don't think there are many people who still believe in the belief that property always rises after the collapse in most developed countries from 2007. If your investment horizon ended then and you were left holding your property portfolio in Dublin with an over 50% decrease in value you definitely wouldn't think that way any more.

               People are always looking for new and innovative ways to invest their money and increase their wealth, with derivatives now being no different from property in that respect. All of which brings me to that second interesting dinner conversation from last week. Whilst pondering whether speculating using derivatives or property was really that much different, I remarked on Friday night that I didn't much see how art existed as a true investment type and wondered where the value was. To my surprise I was given a very interesting rundown on the workings of the art market and how there are specialists out there with a sharp eye looking for the next up and coming artists for investors wanting to diversify their portfolio (and prepared to wait for that patient 20-30 year return). Unless you already have that Monet or Manet in a family collection (or a celler in Munich) then investors now need to find what they hope will be the next big thing. Knowing now whether a Laura Sykes or Zachary Walsh artwork will eventually sell like an Andy Warhol or even a Master seemed to me like an impossibility to predict but, like any investment, there are specialist analysts out there who feel able to give an expert opinion on where the growth prospects are and the right pieces to buy and hold. There's now even funds set up with the sole purpose of investing in art, although the minimum entry is most certainly far beyond that of all but the more wealthy investors. As the number of wealthy investors from the Middle East and Asia look for increasingly diverse ways to preserve and grow their capital, it seems likely that investment in this area is certain to continue to grow, pushing further the value of some pieces. As with any up and coming investment, my dinner colleague maintained that the great thing about art was that "it never loses it's value". As interest in this area as an investment too grows, that interest will begin to spike and values will increase further, because when there's money to be made, everyone wants a piece. However as with all speculative investments be it property, stocks or derivatives there is always dips when money becomes tight and people need to get out and art will be no different, even if we can't see it now. 

Will a Laura Sykes piece be worth the same as an Andy Warhol in 40 years?

  Know what you're investing in

                  My being corrected on the value of art only served further to demonstrate that where one person may see a house as a dwelling or an option as protection, there are others who see the speculative investment prospects in such tools. Whilst I might like a nice painting to decorate my flat, I won't be out there buying art in the hope it'll be worth 200 fold in 20 years time. However that's because I don't claim to understand it. I accept that there are others that do and have the potential resources to take advantage. The truth is derivatives as an investment type isn't much different from any other asset. They all started out as a use for a more practical reasons and are now further tools to make money for those willing to risk it. Just because we don't understand something, doesn't mean there can't be financial benefits to it, but just make sure what you're sticking your money into you do understand. That's the mistake that people make.