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Forex, a value added in an allocation between real and financial assets

The foreign exchange market (Forex) is not an extra asset class but all asset classes together in the same market. It can be a real source of diversification and performance subject to a systematic, disciplined and rigorous monitoring.

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The current crisis in financial markets should be an opportunity to question the traditional asset allocation and suggest investment alternatives sufficiently diversified and uncorrelated with the actual turbulence.

Investing during market turmoil

The idea that considers equity investing as long term has simply become absurd nowadays and has been so during the last 10 years. Let us be reassured. Opportunities will still be around. The only real question nowadays is how to allocate between real assets and financial(...)

Those who have been reading me for 2 years , know that I have never ceased to advocate an overweight of real assets (or financial assets indexed to the growth of emerging economies, the rise ahead of inflation and commodities). The traditional reasoning for the financial assets allocation splintered, the question is not about whether over(under) weighting shares or under(over)weighting bonds, the real question today is to consider the choice between real assets and financial assets. In the article below, I propose an asset allocation target (60% in tangible real assets and only 40% in financial assets) in which we find 10% allocated to diversification support and alternative management in highly liquid investments such as the Forex.

A SOURCE OF PERFORMANCE REQUIRING METHOD, RIGOR AND DISCIPLINE

Beyond the potential value added generated by the Forex, it is naturally necessary to exercise discipline and rigor. I do not want to claim the pitfalls and strategies regularly discussed on Forex sites.

My professional experience over 20 years on the market and my personal experience of trading and investment lead me to highlight some rules and principles of common sense.

-RULE-PRINCIPLE 1. Basic principle, the famous saying "stop your losses and let run your profits", it is human nature to do the opposite, that means taking small profits quickly and not cutting losses. If one engages in a simple simulation, we see how important it is to adhere strictly to the adage. Considering 20 deals during the quarter, 15 deals imagine losing 0.25%, 3 deals significantly winners of 2% and only two highly profitable deals with a performance of 5% in total, the total performance would be 12.3% flat quarterly, more than 60% per annum assuming you reinvest the earnings at the same rate, nearly 50% otherwise. I can assure you that making a serious backtesting, this type of performance is only possible if we do follow this adage : cutting losses quickly and avoid to take profits too quickly , an exercise excessively difficult to do (never change methods and focus on systematic instead of discretionary). And provided also top respect the principles and rules set out below

-RULE-PRINCIPLE 2Differentiate accurately a major trend (in which case the positioning of a stop is appropriate) from a trading range (positioning of individual stop loss not necessarily optimal).

-RULE-PRINCIPLE 3 : A risk management extremely focused on loss aversion. One could compare this principle to a football team that do not play spectacular football aiming to win by 3-4 goals difference (that is the case of a trader setting ambitious performance targets) but a realistic and effective football consisting of not taking goals and, if necessary scoring in counterattack (that is the case of the trader who bet not to lose). It is true that this is not necessarily beautiful but oh so effective

-RULE-PRINCIPLE 4: What behavior vis-a-vis the market? It is often said that the most common error committed in trading is to anticipate changes in currencies at the expense of the trend. We should not anticipate the exchange rate but rather what we will do if the market takes a particular direction. Maximizing the odds of gains in Forex would then be to follow the general trend. It is also necessary that there be a real trend and it is confirmed by the economic environment. In fact, I think frankly that there are as much chances to win or lose depending on whether one anticipates or follows the trend (provided of course to have some market experience and a minimum understanding of market movers that influence currencies)

-RULE-PRINCIPLE 5 : Again, what behavior vis-a-vis the market? Should we then show strong confidence with a risk of ego that can turn against us or follower with the risk of buying into the highest of the range and the risk of selling into the lowest of the range. In reality neither the one nor the other. there are no intangible rules regarding the attitude to adopt vis-a-vis the market: you have to take advantage of irrational fears, but not too much as fighting against the market and feeling invincible / euphoric; but not capitulate, be influenced and impressed.

The foreign exchange market (Forex) is not an extra asset class but all asset classes together in the same market; market that will confront many players with different objectives, different constraints and different investment horizons.
Mory Doré

A REVIEW OF DIFFERENT INVESTMENT AND TRADING METHODOLOGIES

I am often asked by friends and colleagues (as anyone who had gained experience in the financial markets) on the expected changes in foreign exchange rates on the foreign exchange market (Forex). If the currencies traded on the Forex are among the easiest to understand and implement (spot, forward and to a lesser extent currency derivatives such as currency swap and currency options), this market is the one where good bets and good anticipations are often the most difficult to achieve.

Indeed, when it comes to asset classes, we refer to interest rates (money market, government bonds, corporate bonds), equities and hedge funds...But the foreign exchange market is not an extra asset class but all asset classes gathered in the same market; market that will confront many participants with different objectives, constraints and investment horizons.

  • There are foreign exchange transactions said non-financial, for industrials that must hedge sales for export and supplies cost via imports
  • There is also a very timely exchange transactions related to large cross-border merger and acquisitions

Beyond the foreign exchange (very marginal) transactions related to the real economy, there are transactions that are in direct contact with the financial sphere, be it trading, portfolio investment or hedging

  • Proprietary desks from investment banks
  • Asset allocation by institutional investors
  • Hedge funds directional bets
  • Central bank intervention in the management of their exchange rate policies and monetary policy (we will return at length)

At this point, it will be understood that given the diversity of players in the foreign exchange market and especially diversity of motivations for intervention, predict the major directional trends is an exercise almost impossible. certainly, but anticipate, including the foreign exchange market, is necessary for many of us, as from a professional point of view than from a personal point of view, in the context of optimizing portfolio management.

When you are a trader or investor , you need to know how to deal with the world as it is and not that as likely to be
Mory Doré

As I often repeat it to various audiences, to anticipate the major trends in financial markets (equities, short-term rates, long-term rates, currencies, commodities), it is essential to combine four types of approaches and methodologies. The Forex that is the oldest market in the world is no exception

  • appreciation of the markets psychology and understanding the level of risk aversion of market participants - recommendations on the 10% of our asset allocation targets and distinguish trend patterns from trading range patterns
  • Fundamental analysis through the publication of macroeconomic indicators and the anticipation of monetary policy decisions of central banks - medium-long term horizon
  • The complex analysis of anticipating the transaction flows and the structure of volume and open interest positions from large participants such as central banks, big institutions and global macro hedge funds... very difficult to predict but very profitable if we come to detect some changes in behavior - carefully follow principle 1
  • finally, intra-day and intra-week technical analysis, on which I am not an expert but I watch it closely when the three previous approaches do not provide any inspiration - Here as well, carefully follow principle 1

CONCLUSION OR RATHER BEHAVIOR TO ADOPT IN PROLONGED PERIOD OF CRISIS

You will tell me that if we always anticipate the worst, namely the crisis, wars and revolts, we do nothing on the markets...But we must recognize that there is the world as it is and the world as that we want it to be. And When you are a trader or investor, you need to know to live in the world as it is and not that as likely to be.

So this does not mean that you must be outside the markets but it is necessary to be sufficiently diverse, selective in the stock or bond picking, defensive by overweighting the overvalued real safe havens and also as uncorrelated as possible. Remark, we must avoid false uncorrelation that only exist when the markets are calm and that prove to be disastrous when crises occur (which coincidentally was statistically uncorrelated becomes abruptly correlated in times of stress)

Anyone having managed supposedly diversified portfolios know what I mean..So always give priority to highly liquid investment vehicles (regardless of your expectations and whatever the asset class); it is also necessary to seek simplicity and transparency (beware of complex trade-offs based on statistical models that are shattered when markets are experiencing serious disturbances). These common sense tips mean also protecting from the markets irrationality, consequences of forced sales to the value of certain assets, and mimicry.

Mory Doré September 2011

Article also available in : English EN | français FR

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