Liquor, Ladies and Leverage

by Robert R. Johnson

Most investors would be shocked to learn that the biggest financial market in the world is the currency, or forex (FX) market.

While most of the activity in the FX market involves multinational corporations hedging natural positions, some FX market activity involves institutions or individuals speculating on currency movements. Arguably the most famous forex speculation occurred in 1992 when hedge fund manager George Soros shorted the British pound and pocketed a profit of over $1 billion. Despite the potential for large gains, amateur investors are well- served by ignoring the siren call of this enormous and highly liquid market.

The FX market is different to the stock or bond market as it does not set a currency’s absolute value but rather determines the value of one currency relative to another. The US dollar is the most traded FX currency in the world (88% of all FX transactions), followed by the euro (32%). Because each FX transaction involves two pairs, the grand total of all transactions equals 200% and not 100% as in every other financial market. The FX market is highly developed, and you can take a position in virtually any major currency against another major currency. For instance, you can take a position
in the US dollar versus the British pound or a position in the yen versus the Australian dollar.

One of the biggest attractions for many speculators in the forex market is leverage. Leverage involves borrowing a certain amount of the money needed to invest in something. In the case of forex, money is borrowed from a broker. Forex trading does offer high leverage in the sense that for an initial margin requirement. A trader can build up, and control, a huge amount of money. In the stock market, margin trading means that a brokerage firm lends an account owner a portion of the total purchase price (typically 50%), which increases an investor’s buying power. If one buys a stock on margin and that stock rises by 50%, the investor earns a return of 100% (less the interest paid on the borrowed funds). That is, leverage magnifies gains. But, leverage also magnifies losses. If the stock falls by 50%, the investor will suffer a loss of greater than 100% and the investor will receive a margin call requiring him to put up more capital.

Leverage in the forex market makes leverage in the stock market look tame. For most actively traded major currency pairs (such as the euro/ US dollar or the US dollar/Japanese yen), the margin requirement is as low as 2%. That means for every dollar of margin, the investor controls a whopping $50 of currency. Small changes in relative currency values can mean enormous profits if the move is in the right direction or can mean devastating losses if the market moves opposite to your trade.

“Warren Buffett once said ‘My partner Charlie (Munger) says there is only three ways a smart person can go broke: liquor, ladies, and leverage. Now the truth is – the first two he just added because they started with L – it’s leverage.’”

The world’s greatest investor, Berkshire Hathaway Chairman Warren Buffett once said “My partner Charlie (Munger) says there is only three ways a smart person can go broke: liquor, ladies, and leverage. Now the truth is – the first two he just added because they started with L – it’s leverage.”

With the elevated levels of leverage in the forex market, the odds of going broke increase geometrically – particularly for amateur investors. Investing in traditional currencies is fundamentally different than investing in stocks, bonds, or real estate.

Over the long-term, investing in the stock market is a positive-sum game. Over the long run the value of stocks generally rise. On the other hand, over both the short and long-term, investing in currencies is a zero-sum game. When the US dollar strengthens versus the yen, those holding

US dollar positions win and those holding yen positions lose an equal and opposite amount. If you want to build wealth over the long-term, the stock market is the place to be.

Robert R. Johnson, PhD, CFA, CAIA, is a professor of finance in the Heider College of Business at Creighton University in Nebraska and chair and CEO of Economic Index Associates, a NYC-based developer of investable indexes.
He is also co-author of Investment Banking for Dummies, Strategic Value Investing, Invest with the Fed and The Tools
and Techniques of Investment Planning.

For a wealth of investing advice, look no further than Muscle and Health’s Finance/ Money section.

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