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Portfolio Diversification and the Forex Market

July 2nd, 2010 · blog, Guest Post

This guest post is brought to you by Chris Marchalleck, a market analyst for Forex Traders, an online educational resource for the currency trading and forex market.

The Global Credit Crisis of 2008 caught most investors by surprise. It was apparent that a recession was going to hit in late 2007, but very few foresaw the depth of systemic risk that was inherent in the subprime mortgage industry. Then in September of 2008, the bottom fell out of U.S. and foreign equity markets as Lehman Brothers, AIG, Fannie Mae, Freddie Mac and a host of other powerful financial firms began to collapse.

Many investors took enormous hits to their 401k investments and other retirement vehicles. The Crisis of 2008 has challenged several aspects of modern portfolio theory, as many models lost much more during the Crisis than was thought possible. The growth of the online brokerage industry has exploded over the last several years as more people have chosen to begin managing portions of their personal wealth. The purpose of this article is to discuss how one can diversify their portfolio by allocating a portion of their wealth to the Foreign-Exchange Industry.

First of all, we must deal with one of the primary misconceptions of the FX Industry. The commonly held notion among uneducated investors is that the FX Market is extremely dangerous and offers investors little more than a high risk of the loss of all funds. While the FX Market does definitely carry with it the risk of loss, so does every other market, such as equities, commodities, futures, and options. This stereotype has been attached to the FX Market and forex trading because of the incredibly high leverage many brokers offer traders. For example, many brokers will offer up to 200:1 leverage in the FX Market. That means, with a deposit of $1000, a trader could control a $200,000 position in the market. Of course, it is not difficult to do the math and realize how quickly that $1000 will probably be gone.

However, if that high leverage is not used, the FX Market can be an incredible place to diversify a portion of an individual’s wealth. The question is, how can an average investor take advantage of the world’s biggest marketplace?

First of all, if a person has a natural draw to finance and economics, and is currently trading a small portion of their personal wealth in the equity markets with an online broker, transitioning into the FX Market is not that difficult. While learning the complexities of day-trading and swing-trading the FX Market is probably beyond the time available to most investors, long-term position trading is not. It is possible to trade FX Exchange Traded Funds with any of the major online brokerage houses that are currently in the U.S.A. Let’s break down an actual scenario.

The Japanese Yen and U.S. Dollar tend to gain incredible value during times of economic uncertainty and especially during times of global recession. During the recession of 2008, we saw one of the most rapid moves of U.S. Dollar and Japanese Yen strength that the market has ever experienced in one year. By taking long positions in a U.S. Dollar-based ETF, for example, an investor could hedge against the risk of equity markets falling.

Second, there is an industry of financial professionals called Commodity Trading Advisors (CTA’s). CTA’s generally run hedge funds or other large investment pools and funds. Although very large hedge funds often require investors to have a minimum net worth of $1 million and require very large initial investments, there are many other funds operating that require much lower initial investments. This is a second option that allows investors to take advantage of the FX Market by investing in a fund that is heavily or completely exposed to the FX Market. Since CTA’s are regulated by the National Futures Association, they can be researched in very similar ways to mutual funds. By visiting the NFA’s website, you can search for CTA’s and find investment track records, assets under management, etc. There are also several online locations, such as Barclays, that tracks CTA performance.

Many financial analysts are calling for a very slow return to economic vitality in the U.S.A., and that could spell trouble for investors heavily exposed to U.S. equity markets. In 2008, when almost every equity-based fund was losing 30,40,50,60% of its capital, several large FX hedge funds returned exceptional rates. In fact, Renaissance Technologies, owned by Jim Simons, returned over 80% on a multi-billion dollar fund. This is because FX-based funds are able to concentrate their assets in currencies that tend to outperform during times of economic distress.

The FX Market is just beginning to gain more exposure and popularity among investors. By allocating a percentage of one’s assets to an investment vehicle that is heavily exposed to the FX Market, one can better diversify against the risks inherent in an investment approach that is heavily exposed to U.S. and foreign equity markets.

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2 responses so far ↓

  • 1 Johanna Trebel // Sep 3, 2010 at 5:19 pm

    “Many financial analysts are calling for a very slow return to economic vitality in the U.S.A., and that could spell trouble for investors heavily exposed to U.S. equity markets.”

    So true.

  • 2 William Smith // Sep 3, 2010 at 5:23 pm

    When “allocating a portion of your budget to forex”, also keep in mind that you should only trade 1.5% to 2.0% of your balance. Many traders fall prey to risking too much once they gain the overhead. Don’t be foolish!

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