Invert, Always Invert

There is a saying by the famous investor Charlie Munger to “Invert. Always invert”. What he means by this saying is that you must always consider the other side and play devils advocate with you investment ideas or in this case with your FX strategy.

Considering the risk factors of being wrong and thinking through the other side of your strategy is an essential element of your process. This can take many forms. For example if you have decided you want to bet on the Japanese Yen appreciating because you think the Japanese government will raise interest rates due to rising inflation you also need to consider broader reasons why they may not raise rates. Reasons the government may be disinclined to raise rates may include high unemployment or a major shock to the economy (such as a tsunami) affecting the outlook. By considering the other side you may realise a flaw in your strategy and save yourself from a losing trade.

As another example let us consider the USD:HKD trade that I have previously written about. As previously discussed, Ackman has outlined in great detail his thinking behind this trade and it is a very compelling and insightful strategy indeed. However before rushing out and following Ackman, let us consider the “other side”. Let us consider why we shouldn’t make this trade and reasons why this trade may not work.

To begin with, Ackman has logically outlined all the economic pressures on Hong Kong and reasons why it would make sense for the authorities to raise the FX rate to counter these pressures. In reality however the authorities may be loathe to actually do this.

Another potential stumbling block to Ackman’s trade being successful are the HK citizens themselves. HK residents are aware of their Governments lack of enthusiasm for raising the pegged exchange rate and hence the poor store of value that the HKD represents and as such there will be a continued shift to trade in the RMB. In essence this informal use of RMB as a means of payment in HK will essentially become formalised as more and more citizens look to transact in RMB. (Already most retailers price their goods in both currencies). Indeed if this informal shift towards RMD were to accelerate, the authorities job may be done for them and the HKD may just be discarded.

Undoubtedly one of the reasons Ackman has been open about his FX trade position is because he wants more people (including hedge funds) to follow him into the trade which will put increasing pressure on the HK monetary authorities. [From a technical point of view, for HK to maintain the peg, the government needs to buy USD and sell HKD in the currency market. In essence just as we saw with Soros’ famous GBP trade, it becomes the Government versus the currency speculators and who has a bigger bank account]