Derivatives misconceptions week

Last week started with Halloween and ended with fireworks. A week that begins with doing something scary and ends with an explosion.

Maybe we should rename this week and have an annual event called “national derivatives misconceptions week”?

Most people who are new to derivatives will have two worries:

  1. They are “complicated” and scary
  2. They are risky and often lead to blow ups

Working in derivatives I am clearly biased; but I think (and see with clients) that these two concerns are actually the ‘monster in the cupboard’ – scary in theory but not present once you look into it.

It is not that concerns are unfounded. The financial industry has a lot to answer for in the way it has previously talked about derivatives; making them seem like tools for maths geeks. As with anything in life, there are stories of when derivatives go wrong and, understandably, these will be reported (as with any news coverage it would be pretty dull to have a tonne of headlines saying “everything went okay today”), and this increases the perception that derivatives are dangerous.

It’s true that if you use something you don’t understand, and you use it in a complicated way, there is a chance that it will go wrong – and this is certainly true of any investment.

For those new to derivatives, I would simply say there are two critical things to avoid things going wrong:

  1. Effective education
  2. Keeping it simple

I have touched upon the importance of effective education in some of my other blogs. Trying to explain derivatives using technical, alien terms is pointless. It only reinforces concerns about complexity. Proper education is all about starting from whatever basics the trustees in question already have, and building up their understanding until they feel comfortable enough to make a sound and educated decision. For some trustees, this may mean getting into the maths; for the majority, it is about getting to the point where the trustees understand the principles of how the strategy behaves given different market movements.

And this leads to the second point – keeping it simple. A more complex strategy is more difficult to explain and educate on. As it is more complicated, it is more difficult to describe how it performs in different scenarios. Keeping it simple, and steering clear of complex strategies, avoids these pitfalls.

To be clear, I am not advocating trustees to blindly do something based on my assertion that it isn’t scary. Quite the opposite – trustees should absolutely understand, but I think derivatives strategies are far easier to understand than many trustees might expect.

As a non-artistic person, the prospect of carving a pumpkin with my son earlier this week was quite daunting (especially when I looked on google for images of inspiration). However, once I started it became easier.

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