Markets can remain irrational longer than you can remain solvent. Such is the advice John Maynard Keynes is supposed to have given to would-be investors looking to make a killing in the period between the first and second world wars.
There is some dispute about whether Keynes ever delivered this warning. What is not at issue is that it was advice he did not always follow, especially when it came to his dabblings in the currency market.
A new study of Keynes’s attempts to make money out of movements in the pound against five major currencies of his day – the dollar, French franc, German mark, Italian lire and Dutch guilder – comes to a stark conclusion. He was a great economist but decidedly average foreign exchange dealer.
The study found that Keynes “experienced periods of considerable losses in both the 1920s and 1930s. Indeed, he was close to being technically bankrupt in 1920 and could only stay trading thanks to his ability to borrow funds from his social circle.”
He was an avid speculator, playing the stock, property, commodity and currency markets. Details of more than 350 of his currency trades between 1919 and 1939 were kept in the archives of King’s College Cambridge, where Keynes managed the endowment fund.
Two academics who have studied the trades – Olivier Accominotti of the London School of Economics and David Chambers of Cambridge’s Judge Business School – say Keynes was much better at picking shares than he was at currency dealings, and that his chequered record might make today’s testosterone-driven traders think twice.
“Unlike his stock investing, Keynes found the currency market a lot tougher, despite the fact that he was at the centre of the world of international finance throughout the time he traded currencies,” Chambers said.
Overall, Keynes made rather than lost money on currency speculation in the 1920s and 1930s, and the authors of the study say the profits were based on more than pure chance.
“Directionally, he called currencies more or less correctly but he really struggled with timing his trades”, Chambers said. “Hence, one main message for investors today is that if someone as economically literate and well connected as Keynes found it difficult to time currencies, then the rest of us should think twice before believing we can do any better.”
Keynes based his investment strategy on his assessment of the fundamentals of an economy, including the likely trends for growth, inflation, the balance of payments, capital flows and political developments.
Other currency dealers, however, follow different approaches. Some bet on currencies that offer higher interest rate yields over those that offer lower interest – the so-called carry trade – while some simply go with momentum, backing those currencies that have recently been rising.
The research paper, If You’re So Smart: John Maynard Keynes and currency speculation in the interwar years, says the era when Keynes was playing the currency markets was marked by large deviations of exchange rates from their fundamental values. “Implementing a currency trading strategy based on the analysis of macroeconomic fundamentals was challenging [even] for John Maynard Keynes.”
Keynes had a particularly tough time in the 1920s, a period when the pound returned to the gold standard at its pre-first world war level.
The paper says currency traders can be judged by the returns generated per unit of risk, which is known as the Sharpe ratio. In the 1920s, Keynes could boast a Sharpe ratio of approximately 0.2, but those traders using a blend of the carry trade and momentum strategies scored higher at closer to 1.0 after transaction costs.
Perhaps chastened by the experience, Keynes took a five-year break from currency trading and when he resumed his speculative activities in 1932 he did better. He outperformed the carry trade strategy but still did worse than an approach based on momentum.
This article was written by Larry Elliott Economics editor, for theguardian.com on Tuesday 12th January 2016 14.12 Europe/Londonguardian.co.uk © Guardian News and Media Limited 2010