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Buffett on Derivatives: Leverage and Misunderstanding Is a Terrible Combination

Not all derivatives are bad, but borrowing too much and buying something one does not understand is a recipe for disaster

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Jan 21, 2022
Summary
  • Buffett advises investors to stay away from derivatives
  • This statement is not as simple as it sounds
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One of

Warren Buffett (Trades, Portfolio)'s best-known statements is his declaration that derivatives are "financial weapons of mass destruction." The Oracle of Omaha made this statement in his 2002 letter to Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) shareholders.

In the letter, the investor discussed the collapse of Long Term Capital Management, formerly one of the world's largest hedge funds, managed by a selection of Nobel Laureates, which ended up borrowing too much money and collapsed when its models proved useless as market volatility jumped.

However, as is often the case with Buffett's comments, this statement is usually taken out of context. Buffett might have said that derivatives are financial weapons of mass destruction, but using this statement alone provides a much too simplistic view.

A complex market

The derivative market is colossal and complex. There are thousands of different derivatives that provide thousands of different financial structures for investors to take advantage of (or avoid).

Some derivatives can be useful in helping provide hedging strategies, reducing the risk or increasing exposure to specific market themes. Indeed, Berkshire has used derivatives itself in the past.

To my knowledge, Buffett has used derivatives in the form of options to bet on the price of Coca-Cola (

KO, Financial) stock and hedge against the sudden decline in the S&P 500. I would also not be surprised if some of Berkshire's insurance businesses use derivatives in one form or another to hedge interest rate risk and against Black Swan events in the market.

Berkshire Hathaway Life provides tailored insurance policies for the life and health insurance market. As life insurance involves matching long-term assets and liabilities, companies in the sector are uniquely exposed to interest rate changes. Even a small interest rate change today can significantly impact the value of the portfolio in 30 years' time. While I do not have any information confirming Berkshire Hathaway Life is using such a strategy, I would not be surprised as this is a universal approach in the long-term insurance market.

As such, I think it is misleading to say that Buffett believes all investors should avoid all derivatives at all costs. Instead, I think it is worth considering the Oracle's comments from 1994. He made the following statement when talking about derivatives at that year's Berkshire meeting:

"And any time you combine ignorance and borrowed money you can get some pretty interesting consequences. Particularly when the numbers get vague... the ability to borrow enormous amounts of money combined with a chance to get either very rich or very poor very quickly, has historically been a recipe for trouble at some point. Derivatives are not going to go away. They serve useful purposes and all that, but I'm just saying that it has that potential."

Put simply, Buffett was saying that these products do have their uses, but the core principles of investing apply to these products just as they would with any other financial instrument.

If an investor gets involved with something they do not understand, the result could be disastrous. At the same time, if one borrows more money than one can afford, the results can also be poor.

Therefore, the main takeaway from Buffett's comments should not be that investors should avoid derivatives entirely (although some investors may be happy to choose this route to make things simple), but that investors should always apply two key tests to any investment:

  1. They need to know what they are buying. If they do not, it is best to stay away.
  2. Can they afford the trade? If they have to borrow more than they can afford, it might be best to avoid the deal.

Derivatives themselves do not cause problems. It is a lack of knowledge and leverage that cause issues.

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