Shares vs. derivatives: what investors need to know

Shares and derivatives each have their distinct place in investing. Understanding the differences between these two financial instruments can help investors use these products effectively to reach their financial goals.

 Shares

 An easy way to understand what shares are is to think about the meaning of the word ‘share’. Very simply put, having shares in a company means owning a part of it. An investor who owns a share in a company effectively has direct ownership in the company, granting them rights to a portion of the company's assets and profits and the right to vote in company elections.

The investor will benefit from the company’s dividend policy, which contributes passive income to the investor for reinvestment into the market. When considering risk and return, shares typically offer higher potential returns than asset classes like bonds or cash, but also come with higher risk due to the volatility of share price movements.

Derivatives

 Derivative products are financial contracts whose value is derived from their underlying assets, such as shares, bonds, commodities, or currencies. They serve various purposes, including hedging risk, speculating on price movements, or providing leverage.

 Leverage gives investors access to a larger portion of the market with a smaller deposit. When considering risk and return, derivatives can therefore offer high returns, but they also carry higher risk due to leveraging and complexity. Derivatives can complement an effective investment strategy either by protecting the downside of a share portfolio or by providing increased market exposure by leveraging limited cash in a portfolio.

 Key differentiators

 The key differences can be summarised as follows:

·       A share is a financial instrument, while a derivative is a financial contract that references an underlying asset – it can be a share, bond, currency, etc.

·       A share is a perpetual instrument with no end date, while a derivative generally has a fixed term attached to the contract.

·       Derivatives can either be listed – for example, futures or options on futures – or can be over-the-counter (OTC) products, as is the case with swaps or contracts for difference.

·       A share provides an investor with the ability to earn a dividend (subject to dividend withholding tax), whereas a derivative provides the investor with the ability to earn manufactured dividends (subject to marginal tax rates).

·       A share requires an investor to have the full amount of capital available before they can invest in the share, while a derivative contract can be entered into with a smaller amount of capital than what is required to have a sizable position in the underlying asset.

·       A derivative contract requires the investor to add further capital from the start date of the contract to offset any potential negative market movements due to share price changes.

·       Shares tend to be less volatile than derivatives due to the leveraged nature of derivatives.

Assessing your risk appetite

 Investors should carefully consider their risk appetite, as this will assist them in deciding which of these options are best suited to help them reach their financial goals. Warren Buffett is known for saying that “…the stock market is a manic depressive” – a reflection on the volatile nature of share prices. An investor with the emotional intelligence to weather volatility can use it to their advantage when investing in shares and trading in derivative contracts. However, those who lack this resilience may be more prone to making impulsive or poor investment decisions.

 Achieving a good balance

 Determining the right balance of derivatives and shares in a trading portfolio is a very personal decision for any investor and can certainly be influenced by an investor’s trading experience. For those new to investing, there is merit in mostly having exposure to shares and exchange-traded funds (ETFs). As experience and confidence develop, consider using derivatives to leverage market exposure when good shares are trading at notable discounts so that you can benefit from short-term price volatility.

 While there is a fair amount of negative press indicating investors can lose significant money when trading in derivatives, a savvy investor with the appetite to weather market volatility stands to benefit from having exposure to derivatives, especially where this complements an existing share portfolio. As the single asset class that beats inflation over the long term, shares are a necessary investment asset class to ensure that investors achieve their long-term financial goals.

* Myers is the head of securities, PSG Wealth.

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