Can you stomach a bumpy ride?
Contracts for difference (CFD) are a complex financial product. Essentially you are betting on the short-term movement of prices in shares and we all know there isn't much science in that. While it might seem like an easy way to make money, you also have to take on board the possibility of losing the same amount of money in seconds. They do, after all, involve leverage, or borrowings, of over 90 per cent of the principal amount. Like all complex financial products, CFDs can be useful if you understand what they are, but don't use them if you don't.
Trading in foreign exchange is similar to CFDs in that you are betting on second-by-second changes in currencies, which are arguably even more difficult to understand than shares.
Foreign exchange trading also involves high leverage - in some cases up to 99.5 per cent of the amount traded is borrowed. Sure it can be a bit of a thrill to watch gains tick over by the second, but I, for one, am not prepared to pay the price of the reverse happening when I look away from the screen for a minute.
Hybrids, which are a combination of fixed income and equity, are another product you need to understand fully before using. These products have been quite popular lately, as many offer an income that is much higher than the cash rate.
But did you know, for example, that the issuer may have the option of suspending interest payments for a number of years? Or that you would have to line up after senior bondholders and other creditors to get your capital back if the issuing company went bust?
Hybrids are a key area of concern for the Australian Securities and Investments Commission (ASIC). It is worried that they are being sold without a proper explanation of what they are. It has also pointed out that interest from institutional investors - the professional guys in charge of billions - has been poor, which is often a good indication that the issuers might be trying to take advantage of retail investors' lack of understanding.
These products are all legitimate financial instruments, and very useful for some kinds of investors, but the problems revolve around to whom and how they are sold. If the GFC has taught us anything, let's hope it's given us realistic return expectations. If you want returns in excess of double digits, then you've got to take on board the risks that come with it.
One final piece of advice - never be afraid of the "stupid" question. There are none. If someone makes you feel silly for asking one, hang up the phone, leave the room, or delete the email.
Penny Pryor writes a regular column for Sunday Money, in The Sunday Age.
David Potts returns next week.
Frequently Asked Questions about this Article…
Contracts for difference (CFDs) are complex financial products that allow you to bet on the short-term movement of share prices. They involve leverage, meaning you can borrow over 90% of the principal amount, which can lead to significant gains or losses in a short period.
Foreign exchange trading is risky because it involves betting on second-by-second changes in currency values, which can be more unpredictable than shares. Additionally, it involves high leverage, sometimes up to 99.5% of the traded amount, increasing the potential for both gains and losses.
Hybrids are financial products that combine features of fixed income and equity. They have become popular due to their higher income potential compared to cash rates, but they come with risks such as the possibility of suspended interest payments and lower priority in capital recovery if the issuer goes bust.
Investors should be cautious with hybrids because the issuer may suspend interest payments, and in the event of bankruptcy, hybrid holders are behind senior bondholders in recovering their capital. The Australian Securities and Investments Commission (ASIC) has expressed concerns about hybrids being sold without proper explanations.
The Global Financial Crisis (GFC) taught investors to have realistic return expectations. If you seek returns in excess of double digits, you must be prepared to accept the associated risks.
Investors can manage stress by ensuring they fully understand the financial products they are investing in and by only using money they are prepared to lose. It's important to avoid investments that cause undue stress or anxiety.
Never be afraid to ask questions, even if they seem 'stupid.' If someone makes you feel silly for asking, it's best to disengage from that conversation, whether by hanging up the phone, leaving the room, or deleting the email.
Complex financial products like CFDs, foreign exchange, and hybrids can be useful for some investors, but they are not suitable for everyone. It's crucial to understand these products fully before investing and to be aware of the risks involved.
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