When Momentum Turns Against You, Part Two

Warren Buffett’s Warning About Derivatives

This is where Warren Buffett’s famous warning becomes relevant.

The statement is frequently interpreted too broadly. Derivatives themselves are not inherently destructive. Options, futures and swaps have legitimate economic functions. They can facilitate hedging, price discovery, risk transfer and capital management.

The danger arises when derivatives allow investors to create large economic exposures with relatively little initial capital. That creates embedded leverage.

A relatively small amount of capital can control a much larger notional exposure. When markets move favourably, the payoff can be spectacular. When markets move unfavourably, the losses can be equally spectacular.

This is particularly dangerous when the investor does not fully understand the nonlinear characteristics of the instrument. Options are an obvious example. An investor purchasing an option does not simply obtain exposure to the underlying asset’s direction. The investor is exposed to:

The complexity increases dramatically when options are combined with leverage, concentrated positions or short-volatility strategies.

The apparent sophistication of the instrument can therefore conceal a very simple underlying reality: the investor may have taken substantially more risk than the amount of capital initially committed suggests.

The Behavioural Trap: Extrapolation

Behavioural finance provides another important explanation for why investors repeatedly fall into these situations. Humans are naturally inclined to extrapolate recent experience. If an investment has increased substantially for several years, investors begin treating the historical rate of appreciation as normal.

This is related to several well-documented behavioural phenomena:

The investor sees evidence supporting the bullish narrative everywhere. Every positive data point confirms the thesis. Negative information is rationalised. Valuation concerns are dismissed as being “too early.” Historical precedents are described as irrelevant because “this time is different.”

Sometimes it genuinely is different. That is what makes the problem difficult.

A disciplined investor therefore cannot simply assume that every rapidly rising market is a bubble. The appropriate question is more precise: what assumptions are embedded in today’s price, and what happens if those assumptions are wrong?

The Value Investor’s Advantage: Time Horizon and Balance Sheet

This is where my own investment philosophy increasingly converges around one fundamental principle:

This is why exceptional businesses matter. A high-quality company with the following characteristics can continue compounding through market cycles:

The share price can decline 30%. It can decline 40%. It can occasionally decline even more. But if the underlying intrinsic value continues increasing, the long-term investor possesses an enormous advantage: time. The leveraged investor may not.

This is one reason I place such importance on permanent capital loss rather than temporary volatility. Volatility is a market characteristic. Permanent capital impairment is an investment failure. They are fundamentally different.

The Mathematics of Recovery

The arithmetic of drawdowns is unforgiving.

This is why capital preservation becomes increasingly important as losses become larger. And leverage makes the mathematics worse. If an investor is forced to liquidate at the bottom, the subsequent recovery becomes irrelevant. The investor no longer owns the asset.

This is perhaps the most important difference between volatility and risk.

Risk is not simply the probability that an asset price declines. Risk is the probability that an adverse outcome permanently impairs the investor’s ability to participate in future compounding.

The Secular Bull Market Paradox

There is another subtle lesson here. The greatest danger from leverage often emerges during successful bull markets, rather than during obvious bear markets.

During a bear market, investors are frightened. During a mature bull market, investors become confident. Confidence reduces perceived risk. Lower perceived risk encourages leverage. Leverage increases purchasing power. Purchasing power increases prices. Higher prices validate the original confidence. The cycle continues.

Eventually, investors begin believing that risk management itself is unnecessary. That is when the system becomes fragile.

The danger is therefore not simply the existence of leverage. It is leverage combined with confidence, crowded positioning and extrapolated expectations.

History Does Not Repeat — Human Behaviour Rhymes

The famous phrase commonly attributed to Mark Twain, “History doesn’t repeat itself, but it rhymes,” is often used in discussions of financial markets. The attribution itself is uncertain, so I would not confidently assign the quotation to Twain. But the underlying idea is extremely useful.

The exact circumstances of the South Korean market in 2026 are obviously different from China’s market in 2015, the dot-com bubble in 2000, the global financial crisis in 2008, or the speculative episodes of earlier centuries. Different technologies. Different regulations. Different monetary systems. Different market structures. Different companies. Different investors.

Yet the behavioural architecture can remain remarkably similar.

That sequence has appeared repeatedly. The specific catalyst is almost secondary.

The Investor’s Real Objective Is Survival

This leads to a conclusion that I believe is particularly important for long-term investors. The objective of investing is not to maximise returns during the strongest part of a bull market. It is to maximise long-term compounded wealth. Those objectives are not necessarily identical.

An investor who earns 60% during a euphoric year but subsequently loses 70% through excessive leverage has not achieved superior long-term investment performance. An investor who compounds at 15% for several decades without catastrophic losses can create extraordinary wealth.

Compounding is fundamentally asymmetric.

The investor does not need to participate in every speculative mania. The investor does not need to own every momentum stock. The investor does not need to predict every market top. The investor does not need to maximise every year’s return.

The investor needs to remain in the game. That requires discipline around valuation, position sizing, diversification, balance-sheet risk and leverage.

The Final Lesson

The recent South Korean market collapse is therefore more than another severe bear market. It is a reminder of a principle that has survived more than a century of financial-market history:

When leverage increases during a period of extraordinary momentum, the eventual reversal can become disproportionately destructive.

The danger is greatest when investors have become conditioned to believe that recent success is evidence of permanent structural superiority. Markets can remain irrational for considerably longer than a leveraged investor can remain solvent. That is why the most dangerous words in investing are often: “It has always gone up.”

A disciplined investor asks different questions.

That final question captures the essence of long-term investing.

Exceptional businesses can compound capital for decades. But investors can destroy their own compounding through excessive leverage in a matter of months. The market does not need to behave irrationally forever. It only needs to behave differently from what the leveraged investor expected. That is sufficient.

The great lesson from financial history is therefore not that every bull market ends in disaster, nor that derivatives should never be used, nor that every rapidly rising market is a bubble.

The lesson is more nuanced and considerably more useful: never allow the structure of your portfolio to become so fragile that a temporary market decline can permanently remove you from the compounding process.