By Jason Zweig | 5:49 pm ET Jan. 16, 2015
Image Credit: Museum of American Finance
In the financial markets, it is the oldest story ever told. Speculators who think they are investors almost always end up broke sooner or later. The more money they borrow to speculate with, the more certain they are to go broke.
After the Swiss National Bank wreaked havoc on currency markets Thursday by removing its cap on the value of the franc against the euro, major global banks lost tens of millions of dollars on wrong-way bets. The turmoil left a number of foreign-exchange brokers, banks and small traders reeling.
Individual investors hurt by the turmoil lost sight of the most important question they must ask: What is my basic advantage in financial markets dominated by professionals?
The sensible answer is that all individuals can still choose to do what most professionals no longer can: Invest for the long run without having to measure their performance moment to moment in a mad race to beat the market.
But if, instead, you use borrowed money to speculate in markets you don’t understand, you have taken your basic advantage and distorted it into a lethal disadvantage.
People have been trading futures contracts for approximately 4,000 years. The Laws of Eshnunna, a Mesopotamian legal code dating back to around 1900 B.C., regulated futures contracts on tradable commodities such as silver and barley. The Code of Hammurabi, a couple of centuries later, regulated futures trading in grain and sesame seeds.
The use of leverage, or borrowed money, is probably almost as ancient.
In the bad old days of the 19th century, you could control at least $1,000 worth of stock with only $100 down, borrowing the rest on “margin.”
Leaving commissions aside, if the stock went up 10%, you could sell for $1,100; after you paid back your broker the $900 you borrowed, you would have doubled your money to $200. But if the stock went down only 10%, you would be wiped out.
Today, you can generally borrow only 50% against the value of a stock portfolio—meaning that every dollar you invest is backed by 50 cents of equity.
On a retail foreign-currency futures-trading account, however, you can still borrow up to 50 to 1—meaning that every dollar you put to work is backed by only two cents of underlying assets. Not counting commissions, a 2% upswing in whatever you buy will double your money; a downward move of 2% will clean you out. Currencies rarely fluctuate that much—but, as this week showed, every once in a while they fluctuate a lot.
No wonder about two-thirds of individual foreign-exchange traders lose money, according to brokerage firms. In the fourth quarter of 2014, for instance, 70% of accounts at FXCM were unprofitable. FXCM said on Friday that customers owed it approximately $225 million and that the firm was seeking a partner to rescue it.
The average retail forex-trading account lasts only about four months before the trader or the firm shuts it down.
Trading foreign exchange online, in an environment of brilliant colors and dynamic charts, is as exciting as playing the slots in Las Vegas. Brokers’ websites and trading software feel like videogames. Only last month did U.S. regulators finally prohibit foreign-exchange brokers from allowing clients to fund their trading with credit cards.
No one should ever have mistaken such trading for investing.
“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return,” the great investment analyst Benjamin Graham wrote in 1934. “Operations not meeting these requirements are speculative.”
Note that Graham’s definition, which in my opinion has never been bettered, hinges on the word “and,” not “or.” In order for you to be investing rather than speculating, your analysis must be thorough. And your principal must be safe. And your expected return must be satisfactory.
If you trade on hunches or with the same software tools available to anyone else, your analysis isn’t thorough. If you use 50-to-1 margin, your principal isn’t safe; it is in mortal peril. And if you are out to make a quick killing, you will get the returns you deserve.
In short, most individuals who trade foreign currency aren’t investing at all; they are speculating, pure and simple.
Of course, there is nothing wrong with speculating if you do it for the entertainment value and you have money to burn. Gambling in Las Vegas or on a riverboat can be fun, even if you lose money—which of course you will. You get to travel, see some good shows and stuff your face. You may be “on a roll” of wins some of the time; although it is sure to peter out, that streak at the slot machine will be thrilling while it lasts.
But speculating with borrowed money when you don’t have an advantage against the house can be fun only for those doomed few moments when you happen to be in the black. If you play games of chance in a casino because you think you can beat the house, you aren’t there to have fun. You are there to learn an extremely painful lesson.
Source: The Wall Street Journal