The Independent Investor: Does Cash Mean Currencies?

There was a time when one of the rules of asset allocation was to always keep a little cash in your portfolio. Cash was the safest bet you could make. It became the place where we retreated when the markets were in free fall. Today, however, cash as an asset class, earns almost nothing. As a result, many individual investors are using that cash to trade currencies and in the process transform the world’s safest investment into something a lot more speculative.

The headline on the front page of Wednesday's Wall Street Journal read "Currency Trading Soars." The article explained that buying and selling currencies has become a $4 trillion a day market. How much of that volume is attributable to individual investors is hard to measure but from my own experience I can tell you that investing in currencies has never been easier or cheaper. Thanks to exchange traded funds (ETFs), the average Joe has his pick of 44 currency funds that are as easy to buy and sell as individual stocks.

Here in America, where since World War II we have been accustomed to having one of the world's strongest currencies, the desire to invest in other country's currencies has not been high on the list of investment priorities. The currency markets were something that banks used to square up their overseas borrowing or to provide you the necessary currency for your vacation to Hong Kong or Spain. It has only been in the last few years that Americans have begun paying attention to the dollar and its overseas purchasing power.

In other countries, where the fluctuations in the value of their currency can mean the difference between a secure future and poverty, trading in and out of currencies has been a way of life and a traditional avenue of investment. With the introduction of internet trading, ETFs and around-the-clock trading, retail investors in places like Japan, China and throughout the Middle East make a career of day trading currencies.

Clearly currencies markets offer the investor more depth. The currency market, at $4 trillion per day, dwarfs the trading in stocks which is only $130-$140 billion per month. The bond market is much larger and averages $456 billion/day but is still less than half the size of the currency markets.

"The stock markets are totally manipulated by a handful of big players. Bonds provide me less than the rate of inflation. Currencies, on the other hand, can make me a lot of money if I’m on the right side of a trade," argues one retired, ex-Fortune 500 executive who trades currencies by buying and selling ETFs.

During this summer he shorted the dollar (bought an inverse U.S. dollar ETF) and went long the Yen (bought a Japanese currency ETF).

"I made more money in currencies than I made in stocks since April," he crowed.

Although I congratulated him on his investment prowess, I also warned him that he was swimming with the whales in currency markets. Banks, hedge funds and mutual fund currency departments with trillions to throw around can outgun him money-wise, volume-wise and information-wise. These boys also have 24 hour trading departments. If the Japanese government were to suddenly intervene in their currency market, sending the yen dramatically lower (and the dollar higher), my friend could easily wake up tomorrow morning to a sizable loss before he could do anything about it.

This summer's collapse in the Euro was largely triggered by hedge funds. Riding the hedgies coattails works but only until it doesn't. The retail investor was the last to know when those big dogs reversed that trade. My advice to the majority of investors is to keep your cash in a money market and not try to speculate with it in the currency markets.

A better bet would be to buy a country fund or ETF if you believed the prospects of the country were better than most. That way, if you are right, you get a double win both on the country's currency and on its stock market.