A reader writes in, asking:
“I recently saw an article that said that forex trading was invented to be a risk reduction tool. The nature of the rest of the article gave me the impression that it was just fear-mongering. Make me scared about the fate of U.S. Dollars so I turn my money over to them. But if you could discuss the matter in an article on your blog I’d be interested to read it.”
In some cases — which are rare for individual investors — currency-related investment products can be helpful as a way to reduce risk.
Example: Theresa is a self-employed engineer. She lives in the US (and therefore spends pretty much exclusively in dollars), but the majority of her revenue this year will come from completing a project for a client in the UK — a project for which she’ll be paid £70,000. She anticipates completing the project in October. If she wants to, she could use currency futures to “lock in” the current exchange rate so that she knows how much the £70,000 will actually be worth to her (i.e., in dollars), thereby allowing her to budget her finances accordingly.
Most people, however, are paid in the same currency in which they spend. So there’s no need to offset any such risk.
In fact, for most individual investors, foreign currency trading is not only pointless but also harmful.
Firstly, investing in currency is a zero-sum game, before costs. That is, with forex, the investment you’re holding is a currency (or a derivative product whose performance is based on the price of a currency), and currencies do not actually earn any money. (This is quite different from stocks and bonds, which do on average earn money.) With a forex trade, if one party earns money, it is solely because the party on the other side of the trade lost money. And, after accounting for transaction costs, the total amount earned by the two parties is not zero, but negative.
Second, forex allows for degrees of leverage (i.e., investing with borrowed money) that are truly insane for an individual investor. Forex brokers typically allow for 50:1 leverage, meaning that for each $1,000 you invest, you can buy $50,000 of something by borrowing the other $49,000. Investing this much borrowed money wildly magnifies your results, whether good or bad. Of course, the fact that you can borrow huge amounts of money doesn’t mean you have to. But forex does give you the tools to absolutely destroy your finances in a hurry.
Finally, most individual investors don’t engage in currency trading. As a result, you’re engaging in a zero-sum game (negative, after costs) with people who are, in most cases, professionals. They likely have more experience, better skills, and more information than you have.