If you have followed the big financial shakeups of recent history – from Enron to the 2008 crisis to Wall Street Bets – you may have noticed that they frequently revolve around mysterious instruments like “futures,” “options,” “swaps” and the like.
I think many people perceive these as a “fancier” form of investing – more esoteric, complex, glamorous, dangerous, etc. Such practices are not solely the domain of high-flying Wall Street cowboys, however, and can be useful even to average investors.
But first it is crucial to understand that they are not just a fancy form of investing. In fact, I would say they do not qualify as investments at all.
What are derivative investments?
A catch-all term for these financial instruments – which you likely have heard many times as well – is “derivatives.” As the word suggests, derivatives have no inherent value and instead derive their value from some underlying asset.
Specifically, they often take the form of contractual agreements around that asset. For example, something like, “If the price of Asset X goes above Y amount, then Party A will pay the difference to Party B. But if the price of X goes below Y amount, then Party B will pay the difference to Party A.”
The derivatives market is extremely diverse, but here are some of the most common types:
Broadly speaking, derivatives are great for 1) hedging your investment in the asset in question, or 2) gambling (i.e. speculating)on the asset’s future price. Neither of these truly qualify as investing, however.
Why derivatives are not investments
Think for a moment about how you would define “investment.” What does it mean to invest in something? I would not necessarily say there is one right answer – but I would say that different definitions yield different behavior.
For many people, investing means something like “putting my money in a place where I think it will grow.” That definition is not exactly wrong… but it is very vague. You could also define “gambling” the same way; consequently, people with this idea will often struggle to tell the difference between the two.
I prefer another definition:
“Investing” means having ownership in something of value that you believe will become more valuable over time.
Under this definition, your investment decisions are based on analysis of an asset’s value, rather than counting on luck or your ability to tell the future. It excludes hedging and speculation, as well as securities designed for those purposes.
Again, this is not to say derivatives are bad. They certainly have their uses, because hedging and even speculation have their uses as well. Sometimes they serve other purposes too. Stock options, for example, are commonly used as an incentive for employees to invest (literally) in their company.
In any case, the point is this: You are far more likely to use derivatives wisely – should the occasion arise – if you understand how they are different from other investments.