22. ForEx and Magical Thinking

In my last visit to Israel I was asked for my opinion about a new, exciting, trendy way to make easy money. My friend N., a smart guy by any measure, recently went to a presentation about "ForEx", or foreign exchange trading. The idea is simple: currencies trade against each other all day long, and by identifying patterns that are "bullish" (the Sterling is rising!) or "bearish" (the Euro is falling!), you can buy low, sell high a few minutes later, and make tons of money. Better still, you don't even need to sit in front of the computer to do it: sophisticated software will identify these scenarios for you and issue buy and sell orders.

The presenter described how he'd been working for many years on developing 7 fail-proof strategies. He claimed that they have 90% success rate.  And of course, he'd be happy to share his success with all of us, out of the kindness of his heart. Charity has not passed from the earth!

Sounds too good to be true? Get Rich Quick schemes usually do, and this one is no exception.

Micro-trading has been around for a long while. Most day traders you'll see are broke, but ForEx day traders should be even worse off. The reason is that, while buying and selling stocks based on past performance is a folly, you at least own stocks -- which generally, over the long term, appreciate in value. You're just doing it in an especially counter-productive, expensive way. But currencies just trade among themselves, and the average yield on currencies is, by definition, 0%. 

When it comes to stock prices, academic research shows that past performance is no guarantee of future performance. Even worse, the past carries little to no information about the future, and whatever minimal gain you might extract from the analysis is lost when taking into account transaction fees. This is the random walk theory, made famous by Burton Malkiel in his groundbreaking book A Random Walk Down Wall Street. And no, the theory does not say that stock movements (or currency movements) are random - by all means they are based on the cumulative fears, hopes and of course information that traders have. The theory just states that they behave as if governed by random walk rules, in the sense that at any given moment, your current location (i.e., stock/currency price) is all the relevant information you can retrieve from the graph of the stock performance. IBM's stock price in the 70s is not relevant to whether it will go up or down tomorrow, or next month, or next year. IBM's stock price last week is as irrelevant. Add it all up, and you see that it's quite plausible that IBM's stock price in its entire history is not relevant to the prospects of the stock in future. 

But the human mind hates randomness. We try to find patterns in the world. When it comes to stars, it's called "astrology". When it comes to coffe, it's called Tasseography. And when it comes to stocks, it's called Technical Analysis.

The people who try to tell you otherwise use stock charts as crystal ball made of cups, deeps, heads and shoulder, fulcrums and other more exotic vocabulary of shapes. Based on these patterns, they predict where the stock is headed.

Of course, to be on the safe side, their predictions are always vague. Take for instance this guy (quoted from "A Random Walk Down Wall Street"):

The market’s rise after a period of reaccumulation is a bullish sign. Nevertheless, fulcrum characteristics are not yet clearly present and a resistance area exists 40 points higher in the Dow, so it is clearly premature to say the next leg of the bull market is up. If, in the coming weeks, a test of the lows holds and the market breaks out of its flag, a further rise would be indicated. Should the lows be violated, a continuation of the intermediate term downtrend is called for. In view of the current situation, it is a distinct possibility that traders will sit in the wings awaiting a clearer delineation of the trend and the market will move in a narrow trading range.

Sounds familiar, right? Every time I read stock analysis it's a similar dribble. But if you read it again, this guy is basically saying that if the market does not go up or down, it's going to stay flat. Amazing. 

Or perhaps I don't give these people enough credit. As N. continued to tell me the story, we both realized that there is one safe way for making money with technical analysis and ForEx. And no, it's not actual trading. One of the questions you should always ask these geniuses is: if they're so sure of their analysis and their chances of success (90%, no less!), why are they wasting their time here, among mortals, instead of making millions and retiring to Ibiza? The answer is, of course, that the only way to make money out of this voodoo magic is to sell it. This particular course N. was offered was about $3,000. Multiply it by 10 fools a month and you'll get a nice income stream. Good luck!