If you are new to investing and you surf the web for information, you’ll see all sorts of ads promising instant riches, making you wonder how come you’ve been so slow to catch up with the game of getting wealthy without working.
What new investors may not be aware of though is that most of the vehicles proposed to obtain those instant riches involve extreme risk and have a low probability of success even for professional investors.
Forex is short for “foreign exchange”. This is supposed to be the “exciting” place where you can exchange Dollars for Euros, or something more exquisite like New Zealand Dollars. The ads then tout the leverage ratio offered that can go up to 400:1 at some online brokers. Then the ad goes on to describe the excitement of trading forex and how trading forex profitably is so easy that you can expect your wealth to grow increasingly, immediately and immensely. Most ads are a lot less willing to come forth with the risks which usually appear at the bottom of the ad with an asterisk and in small font “Currency trading involves risk.”
Risks: There are traders that make steady, sizable profits from trading forex. However, they are usually quite experienced in what they do and have a large bankroll to absorb a string of losses. They also don’t use 400:1 leverage (surprise surprise!) or anything close to that. Novice traders are prone to trading emotionally, and excessive leverage is giving them more than enough rope to hang themselves. The forex market is also very volatile. Things often happen that are unexplainable. I remember clearly on 7/20/2005, the Euro started rising against the US dollar for no reason at all. It kept rising consistently despite no major news on the economic front. The next day, the world found out that the Chinese Central Bank was buying to diversify its basket of currencies before allowing the yuan to appreciate.
During the commodities bull market a few years ago, many small investors were attracted to the futures market. Corn, copper, soybeans, oil, “Gotta Catch ‘Em All” or so the ads would have us believe. Prices for commodities were supposed to be soaring through the roof and the margin requirement to participate in the orgy would only be a thousand dollars!
Risks: The purpose of the futures market is to transfer risk from producers and hedgers to speculators. This implies that the odds are against small-time inexperienced investors. Other than the risk of being over leveraged that exists in forex, futures also have something called limits. Suppose you were short oil on margin and war broke out in the Middle East. Oil prices could theoretically move “limit up” successively and your stop order may not be able to be executed at the price you placed it. In short, you could end up owing your broker thousands of dollars, which is much worse than just losing all of your money.
This is another highly touted “investment” vehicle. Options are “prized” for their leverage (Yes, that word again). By putting up a small amount of money, you could bet on or against a financial product and get filthy rich.
Risks: It is often said that over 90% of options expire worthless (CBOE claims 60-70%). Options are decaying assets, which means their value erodes as time passes. The market is essentially unpredictable and novice investors usually don’t have the Holy Grail they think they do (or are led to believe they do.)
All of these three instruments tout how you can make money in a bull and bear market. But this is a lot harder than it appears. Timing the market is notoriously difficult as “the market can stay irrational longer than you can stay solvent.”
4. Other High Yield “Investments”:
You will often see ads that guarantee your becoming wealthy in a short amount of time. If you see those ads, RUN! Even Buffett was only able to compound his money 20% annually. If something sounds too good to be true, it probably is.
Investing is difficult, regardless of what investment vehicle a trader uses. Greenspan notes how banks made lots of money from forex. Upon close scrutiny, he found that the banks made most of the money from the spread (the difference between the rate a buyer buys a currency and a seller sells a currency) instead of trading. It is that difficult, even for professionals!
As Peter Lynch once said, “I have become cautious after seeing the huge transfer of wealth on the futures and options markets. (paraphrased)” We believe it is fitting for novice investors to think twice before committing money to these investments. Investor Caveat!
This was a guest post by StockTradingToGo Community member Allen. Other recent posts from this author: