At a high level, if someone can’t tell you what they do for a job, there’s a high likelihood they either don’t do much of anything all day, or they have a need to be thought highly of by others. Just about anyone should be able to break down into one sentence or a few words what it is they do. Even the most complicated technical job, like an airline pilot, can be broken down into something simple: I fly planes. Everyone knows what a plane is, everyone knows they need someone to fly it. The explanation is easy. The pilot may qualify her answer and get more detailed on the type of plane, on the airline she flies for, what route she flies, the pilot ratings and qualifications she has etc. but the concept remains the same: I fly planes.

Now let’s move to a banker. I have delighted for years in the ambiguity of saying that I am a banker with no further qualifiers, and seeing how people try to inquire and figure out what this means in more detail or if they simply don’t care (probably because it sounds boring to them). Some will ask does this mean I am a teller at a branch? Am I a loan officer? Do I sell mortgages? Or on the other end do I manage wealthy clients or perform investment banking services? Someone who may seek validation may start with a differentiator: I am an Investment Banker, and wait to see the impressed look upon everyone’s faces.

Much of what pays in the world comes through specialization. Everyone knows what a pilot is but there are only about 100,000 commercial pilots in the United States and the number that fly commercial jets are a subset of that. Likewise for other areas like law. Most people know what a lawyer is but being a lawyer isn’t always lucrative. A freelance injury attorney may not make as much as a project finance attorney who specializes in public private partnerships law at a large, well regarded law firm. To people not active in a particular profession, these wide variations in pay and specialization are not obvious and many of those that are highly specialized would like to distinguish what they do that sets themselves apart from the “others.” So it’s a challenge for many of those who are highly specialized to explain what exactly it is they do on a day to day basis.

Yet even the most complex role can be simplified if people can put their ego and entitlement aside. Even a specialized role at a bank can be simplified in its explanation and broken down to a real world, relatable example. Over the years at my own job, I have shed the embarrassment of asking questions that some may deem to be stupid or simple. It takes confidence and fearlessness sometimes just to ask a very simple and basic question when you don’t understand something, but chances are, if you are in a group of people, there is at least one or two other people that had a similar question but didn’t have the wherewithal at that moment to speak up. When things get too complicated and I can’t follow them, I try to break things down to the individual level. I ask things like, “If I’m the client and I need to pay my client in Europe five million euros and I come to you the bank, what will you do for me and how will you facilitate that payment?” This allows me to simplify my thinking and bring the person explaining it back to the very simple and raw level of trying to think of things in laymens terms and leave out all the technicalities.

Connecting Big Banking to the Little Guy

I thought of this approach when I was speaking with the derivatives sales and clearing desk the other day. Specifically, we were talking about futures contracts versus bilateral counterparty swaps. Those are the technical terms for the business, but the problem is a very simple one: how do you go about paying a bill in euros when you make dollars? How can my bank solve that for the client? This desk services some of the largest and most well known ETF’s and banks in the world and most of us would think what these institutions do in their day to day has nothing to do with us but the reality is, the only difference is the scale and the size of the transactions. Don’t believe me? Let me break it down even simpler, which is what I asked the derivatives desk salesperson to do. His explanation went something like this:

Individual Company Stocks

Let’s take the example of John Doe who wants to invest in stocks. Joe has the option of buying individual stocks, an ETF that tracks and index or options. Each has their own risk and reward profile. In a single stock, John has single company risk. It could end up having an executive who embezzled money, it’s operations could produce an environmental disaster or it could be come insolvent in a financial crisis. No matter what the company does, the risk something will go wrong will increase over time. Cigarette companies were some of the best stocks to own prior to the 1990’s yet the tide of public health and public opinion changed dramatically at that point and the cigarettte companies were found to be libel for thousands of deaths. The lawsuits and government intervention almost sunk the companies for shareholders.

Or take a less nefarious product like sneakers. You would think this would have little chance for scandal but in the late 90’s, Nike stock suffered as it was revealed that the manufacturing of much of their shoes came by way of sweatshop labor in Asia. The company eventually weathered the storm but was the butt of jokes and late night comedian fodder for years. It took the company many years of underperformance to climb back and re-establish their reputation.

Despite these downside risks, the flip side of the single stock risk is that it can beat the market handily over time if the right stock is picked.

Index Investing

The next lower risk option for John is to diversify. The single company risk disappears when he buys an ETF that tracks and index like the S&P 500. The risks tend to be more systemic with this type of investment, meaning risks are more about big picture events like the financial crisis of 2008-2009. That was a bad time when many lost money but most investors didn’t lose everything. The chances that every firm in America will go bankrupt is extremely low. Price risk is the main concern here. The market may be richly valued overall, as it is now. Historically this has lead to low periods of future returns when invested at such richly priced levels.

In exchange for this lower risk, returns will be more limited but this is why financial advisors and experienced investors counsel people to invest for the long term and stay in despite the ups and downs. Just look at the difference of investing $200 per month starting at different ages over one’s lifetime:

Yet there is another concern for John which is relevant to both him as an individual investor: what if he doesn’t have enough money to buy a share or an ETF? What are his options? Or what if he would like to actively monitor the market and make directional bets on its performance yet has little money?

Or to frame the problem a different way, what if John wants the upside of a single company stock but doesn’t want to deal with the risk that a single company goes bankrupt or does something wrong? This case is where options can be advantageous for John.

Options Investing

This case will require the purchase of options on the index. Luckily options on the S&P 500 are easily bought and sold. In finance jargon, we say they are very liquid. Options would allow John to experience big upside if the S&P 500 goes up. The pricing is a bit complicated here and beyond the scope of the post, but the point that readers can take away is that an option contract can offer 15 to 20 times the return to a 100 point movement in the index (right now about a 2% return) when starting out.

It’s worth being said that this is a highly risky strategy. People can easily be wiped out investing in such a strategy. It’s one reason that many new investors in options may be losing money in the current mild correction environment.

For those with interest here, measured risk is the name of the game. In order not to lose huge sums, even those with tens of thousands may only want to try a few hundred dollars investing in options. They will be closely managed and they will be risky, yet the interesting point here is that the choice is there for those willing to learn about it.

Back to the Derivatives Desk

So now going back to how this may relate to my discussion with the derivatives desk, this desk sells to corporate and bank treasurers, meaning the people who are in charge of all the day to day money needs of the corporation.

This person or team will have needs to invest to protect money saved of the corporation and grow it. They can enter into a swap with a bank to protect their money and grow it over the long term. We can liken this to investing money now to be able to spend it later in retirement. This is somewhat analogous to the index and single stock example.

For the corporate treasurer, the swap will require more time, money and effort. They will have to choose a bank, negotiate contracts and the swap will require more money up front. The advantage is, once it is established, it is very much set it and forget it.

If that same treasurer would like to use less funds but more actively manage their portfolio, then instead of options the treasurer would invest in futures. Just like options on the S&P 500, they would have an expiration date and would be cheaper to enter into, albeit with the risk similar to what I discussed with options.

It’s All Connected

The tie in for all of this is that some of the same products small investors may use from, individual stocks, to ETF’s to options may have that same desk I spoke to connected to them in the background. Self empowerment for investors lies in understanding that things are all connected and it isn’t some machine that runs counter to their interests. Once people start to believe there aren’t any smoke and mirrors – that most things are just a set of tools to achieve an end – the wealthy and large institutions lose a bit of their power. That is a good thing.

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