Investment: Sympathy for the devil

One morning, a few months ago, I woke up to discover I had turned into an Irish bank. This came as a surprise. I had no more seen my financial crisis coming than had the other Irish banks, and like them I found it acutely embarrassing. Unlike them, unfortunately, I had incinerated a pile of my own money rather than torching someone else’s savings.

I did this spread betting—which, I must stress, is a fun and potentially very profitable activity. They say that in investment, your mistakes teach you far more than your successes. If so, then spread betting offers unparalleled opportunities to learn.

It’s easy. All you do is deposit money in an account and start betting on whether a huge range of securities will go up or down in price. If you bet £10 that shares in Company A will rise, you win £10 for every penny they go up. If you’re wrong, you lose £10 for every penny they fall. What could be simpler? The twist is that, whether or not you realise it, you are boosting your betting power with borrowed money: your £10 bet will comprise perhaps £7.50 provided by your spread-betting firm and just £2.50 of your own. This is the genius of spread betting, and also the curse. If all goes well, you’ll make many times the amount you have staked. If not, the opposite will happen and the next thing you know, your depleted sliver of capital is supporting a vast deadweight of bad debt. Hey presto, you’ve turned yourself into an Irish bank.

Smart people mostly use automatic stop losses when spread betting. These will close a failing bet once the loss hits a certain level and so prevent things getting out of hand. I now realise they’re a great idea. But this was a lesson learned the hard way.

On went the bet, a large wager that shares in a particular company would rise. I was so confident I was right that I didn’t set a stop loss. I was backing a British company, but it might as well have been a Dublin property developer. You don’t see what you aren’t looking for: if you don’t think that property prices are going to fall, you don’t worry about how to protect yourself if they do. Over-confidence, combined with easy borrowing, can lead you into a dark corner whether you’re a bank with a room full of risk managers or an opinionated punter.

The next bit is obvious. In my case, a profit warning followed by a huge and instant fall in the share price that I was betting would rise; in the banks’ case, a sudden loss of confidence and a crash in property values. The results had certain parallels.

Once you have a large unrealised loss on your balance sheet you’re in a whole new game. There are the psychological traps. A loss is only a loss, you tell yourself, when you crystallise it. Until then, it’s a problem waiting for rising asset prices to make it go away. So you stick it out, hoping for the best. But that leads you into deeper problems. With a large chunk of your kitty wiped out, you are horribly undercapitalised, which has several consequences. First, if another of your investments blows up, you’re even less able to take the hit. Second, you start having to liquidate good investments to cover the losses on bad ones. This does little for the quality of your balance sheet. Third, you become extremely risk-averse and so fail to back sound investments even when you know the risk of failure is small. It was only having blundered into all these traps that I realised what it feels like to be a banker in a bind.

Mistakes like this one are rich in lessons. Not setting stop losses is extremely risky. But although setting one up is easy—you simply specify, either when you put the bet on or later, at what level you want to close it if you are slipping into the red—it is a tricky operation to get right. If you try to limit potential loss too much and set the stop close to your entry level, the day-to-day volatility in prices (particularly in today’s jittery markets) can bounce you out of a bet, forcing you to take a loss. Typically, you then watch in fury as the price rebounds.

What’s the solution? I’ve come across a couple. First, look at the recent past and take notice of the levels at which a price has either bounced when falling, or at which it has seemed to hit a ceiling. These can help in working out where to set a stop loss, though they’re far from infallible. The other lesson is not to have all your capital in play: leave yourself a cushion that can absorb (hopefully temporary) shifts in prices that push you into the red. If you’ve bet the farm, losing it is much more likely.

Turning myself into an Irish bank was humiliating, but it gave me a valuable lesson in the need to think clearly about risk. Would that Ireland could feel so sanguine. They used to say that if you owe the bank £1,000, it’s your problem, but if you owe it £1m, it’s the bank’s problem. No more. Whether you’re a chastened spread better or an Irish taxpayer, you’re no longer under any illusion about whose problem it is.