AN OLD POKER JOKE GOES LIKE THIS: If you look around the table and you can't spot the sucker, the sucker is probably you.
Looking around for places to invest their money, Americans in recent years have taken their seats at Wall Street's big casino as never before. Fewer than seven years after the crash, 61% of small investors' money is riding on publicly traded securities, up from a 46% share in 1987. More than $1.3 trillion has flowed into mutual funds since the 1990s began, bringing the total to $2 trillion.
Americans have had lots of good, sensible reasons for doing this. The economy finally seems robust, growing a vigorous 7% in the fourth quarter of last year. Corporations ranging from Sears to the papermaker Pentair, Inc. had + record profits last year. Low interest rates have made bank accounts less attractive, and real estate is no longer for those looking to get rich quick. Even after last week's turbulent retreat, the Dow Jones industrial average closed at 3636, 53.7% higher than in October 1990.
So to those gamblers nervously tracking the Dow last week: Don't fret too much; this could be a natural correction. The more unsettling news is happening off the casino floor. For it is there, in the back room, that the big boys have been playing an even faster and bolder game, the outcome of which can affect the little guy's winnings. Much of the smart money is really riding on computer-generated, hypersophisticated financial instruments that use the public's massive bet on securities to create a parallel universe of side bets and speculative mutations so vast that the underlying $14 trillion involved is more than three times the total value of all stocks traded on the New York Stock Exchange in a month and twice the size of the nation's gross domestic product. Collectively, these new financial instruments are called derivatives. Financially, they function like some giant unseen asteroid -- they influence the markets' movements with a powerful and dimly understood gravitational pull. And if they wobble out of orbit, they could conceivably come crashing into the sphere of day-to-day investments with cataclysmic effects.
Derivatives, which are based on such real assets as stocks and bonds, work like most professional betting games. They have a zero-sum outcome, always producing a winner and a loser. The bettors put up their money, and the people who run the casino -- a bank, a brokerage house or an insurance company -- figure out ways to pass on the risks. Companies use derivatives to hedge against changes in interest rates, foreign-exchange rates and commodities prices. Mutual funds and pension funds use them to protect their stock and bond investments. Major banks, brokerage firms and insurance companies write them for customers, inventing such exotic names as forwards, caps, collars, swaps, options and swaptions. Derivatives can be as straightforward as options to buy or sell securities or as fancy as unregulated and customized agreements to purchase oil futures in Nigeria while selling dollars in Indonesia and graphite in Madagascar.