those caught up in them almost never know exactly when, or how
much, a currency will move. That is because the “X factor”—the
element of the unexpected that is present in all markets—is far
more potent in the foreign exchange market.
Clive Crook, in the Economist (May 2, 2003), explains why. It
is conventional wisdom that increased trade in goods and services
is beneficial because it offers consumers more choices. Americans,
for example, can match their tastes and preferences to a wide variety
of automobiles, mostly because of open trade. The Forex market
is good for the same reason—it offers people more choices.
They can also invest in currencies from around the world, each
with different strengths and weaknesses. But, as Crook darkly
notes, the increase in the number of choices also increases the
chances that the investor will make a bad investment. And whereas
most people can tell a well-made car from one of poor quality, currencies
are far more difficult to understand and judge.
For one thing, investors are less able to make an intelligent
decision about something in a foreign business culture than
about something that is near and familiar. Hence, investing in
foreign capital raises the odds that investors will make lesssound
selections.
This would not be as serious if investors were stung only when
markets went down and investments went sour. Yet dramatic currency
swings are rarely so kind. They can quickly spill into surrounding
financial sectors and trigger a series of falling dominoes
of failed institutions—companies, funds, banks, central banks,
and governments. Individuals, who may have no interest in or
understanding of the foreign exchange market, can ultimately be
just as devastated as the investors.
Crook writes about why investor ignorance of the forces
behind currency movement compounds the likelihood of a destabilizing
crash. “Investors tend to deal with uncertainty in ways that
aggravate the problem. If information about underlying value is
absent or obscure, they are likely to become preoccupied with the
views of other investors.”
This isn’t necessarily a bad thing, observes Crook, because one
investor can learn something important that is spread quickly to
the rest of the investing community. But “now and then, it degenerates
into crowd hysteria.”
Several times in history, investors have acted more like sheep
than investors who respect reality, and not just in the Forex markets.
The stock bubble of the late 1990s is a good example, when
seasoned market watchers such as Warren Buffet withdrew in disgust
from the markets because the valuations were so out of line
with earnings.
Because it is difficult for investors to understand what conditions
are like in another part of the world, the global currency market
is therefore prone to these wild, speculative swings.
Another factor, however, makes the currency markets even
more susceptible to swings—leverage. Through leverage, as you
have read, an investor with modest assets can draw on enormous
sums to invest in the foreign currency market, thus making an
oversized impact. I have strongly recommended that the average
investor avoid this temptation. Through leverage, it may be possible
to win big, but it is also possible to lose even bigger.
These losses wipe out the individual investor, but they also
affect the various lenders who loaned the investor the money in the
first place, who often didn’t fully understand the risk they were
taking on. Thus, financial institutions can suddenly melt away after
the disastrous trades of one dealer.
Read More: The Inherent Instability in the Forex Market
