Derivatives

For all you investors and wanna-be investors out there, be like Elmer Fudd: be vewy vewy careful… of derivatives.

Derivatives can make you a profit, but you need a great deal of skill and time to do so. You also need to be happy to carry high levels of risk, and to wear very large losses.

What is a derivative? Anything that’s not a hard, tangible asset. Examples that quickly spring to mind: options and contracts for difference (CFDs).

For fear of legal action I cannot mention the names of companies touting “schemes” to make you rich by trading in derivatives.

Instead I’ll quote some wise words from Warren Buffet in his 2004 annual letter to shareholders:

Though derivative instruments are purported to be highly liquid and … we have had the benefit of a benign market while liquidating ours … Like Hell, derivative trading is easy to enter but difficult to leave. (Other similarities come to mind as well.)

The real test of the earning power of a derivatives operation is what it achieves after operating for an extended period in a no-growth mode. You only learn who has been swimming naked when the tide goes out.”

In the Australian market in the last couple of years, a dead donkey could show a profit. The real test (as above) is to look at performance when markets are flat or falling.

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Warren Buffet is Chairman and CEO of Berkshire Hathaway, Inc, and one of the worlds richest people. He built his fortune (and that of his shareholders) purely by careful investment in the share market.

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