When it's gambling, not investing

The internet is credited with the democratisation of investing. Anyone with access to wifi can set up a trading account and pitch cash at different investments. That’s great. The problem is that not everything on offer is an asset with the potential to grow in value over time.

That’s why I don’t have a problem with the announcement by money watchdog ASIC that consumer protections are being strengthened around ‘contracts for difference’ (CFDs).

If you’re not familiar with CFDs, they involve taking a view about how an underlying asset will change in value over time. You don’t actually buy the asset as you would with, say, direct share investing. What you’re really doing is taking out a contract with the provider – some would call it punting – about how a market will move.

CFDs can be used to trade commodities, futures, foreign currency, cryptocurrency, sharemarket indices and individual stocks. The thing is, over the very short term, like a couple of days, these markets may move very little. Enter leverage.

Leverage amplifies your exposure to market movements. So instead of profiting on a daily market movement of just a few percent, you can make 500 times that movement. Make a wrong call though, and leverage can see you lose far more than you chipped in, potentially leaving you owing money.

For an idea of how things can go pear-shaped, ASIC found over a 5-week period between March and April 2020, ordinary Australians investing in a sample of 13 CFD issuers made net losses of more than $774 million. That’s not a one-off. In 2018, 41,000 retail CFD accounts ended up owing a total of $33 million.

Thankfully, ASIC has stepped in and cut the leverage limits on CFDs. The maximum leverage available to retail clients now is 30:1. Previously it was as high as 500 times the original outlay.

What’s interesting is that the websites of CFD providers typically feature written warnings that CFDs can result in losses exceeding your initial deposit. Maybe people don’t read it, don’t understand it, or just feel confident they can beat the market.

Whatever the case, CFDs are not an isolated product. Foreign currency trading and cryptocurrencies can carry much the same risks around speculation and leverage.  

We all want to earn big returns – and the sooner the better. But in my books, punting is not the same as investing. Add in leverage, and you raise the stakes considerably of losing money. Investing for the long term in tried and tested assets like shares, property, and exchange traded funds may not make you wealthy overnight but it’s far more of a sure thing that you’ll build wealth.