Author, speaker and friend Mary Hunt of Debt Proof Living asked me recently to write an article about Credit Default Swaps, and I thought that was a great idea, and while I was at it, I thought I’d expand the subject to address complex investments in general.
The simple answer to this question posed, is yes they are worthy of consideration. Some of them may be wonderful investments. Many experts think that If you don’t understand it, don’t buy it. So before you invest in something, be sure to read everything you can get your hands on, both negative and positive. Also, talk to the person selling the investment and others that don’t have a personal interest, at length until you understand them before purchasing.
First of all, what is a complex investment? All investments, no matter how simple it is, has many levels of risk not just the conventional different types of risk. Firms will often try to manage these risks to provide a higher rate of return, and here’s the catch, with less risk. They attempt to do this with a whole host of mechanisms that they think will be triggered to help them earn the expected rate of return or minimize risk. The people that build complex investments are really smart and they can, through all types of mathematical probability testing, illustrate how their system will work. However, time and time again these smart guys weren’t smart enough to predict all factors of the future, because as Yogi Berra says “Prediction is very hard, especially about the future.” The darker side of these investments is that intellectual integrity is sometimes compromised by the motive for profits.
The other types of complex investments that warrant much caution are those that have special tax angles, many moving parts to manage, or have an insurance element. Investment of these types such as real estate, retirement plans and life insurance and annuity products can be very good, but require careful consideration first I think. My friends in the insurance industry may object to this point of view, however let me first state I like many of their products, but most of the people who contact me who are most upset over their investments, have either investment real estate or insurance products. Again, if people choose these, they would be best to understand all aspects of their ownership first and purchase them from professionals who take the time to educate and serve them for the long-term.
Commodities and derivatives are also investments that warrant extreme caution, since they have a high potential risk of loss of the entire amount invested. Commodity investing usually entails purchasing metals or agricultural products at a low price and selling them later at higher price. Derivatives are contracts between parties that specify conditions, under which payments would be made, if the conditions are met. The derivatives contracts can involve stocks called stock options (called puts and calls), commodities and even credit (bonds). All derivatives should be considered high risk, and only for very wealthy and sophisticated investors. Credit Defaults Swaps are a type of derivative that can be purchased for multiples of millions, and are a form of insurance often used to protect bond holders if they are defaulted. The problems that have arisen around CDSs are that they were sold to investors for a very low price and didn’t reflect or communicate the true costs and risks involved. Rating agencies rated bonds higher than they should have, and the insurance premiums were too low. Investors were attracted to them because they were told the risks were low and the rates of return were higher than they could get in investment of a similar risk. There are trillions of dollars invested in CDSs, maybe not by you, but by institutions you work with, and could lead to further economic turmoil if they further weaken.