What is Hot Money?
Hot money is the investment of funds between varying vehicles or assets in order to increase capital gains. In other words, a hot money strategy can be defined as the practice of actively using funds in various investments rather than just letting a single investment appreciate over time. The investments are generally short-term and high-risk in nature with the potential to provide substantial payouts. They can include:
The Purpose of Hot Money
Hot money investments serve only one purpose. The goal of an investor adopting such an investing strategy is to make as much money as possible, as soon as possible. Investors do not want to wait weeks or years for their returns.
One good example is the Bitcoin craze toward the end of 2017, which saw the cryptocurrency shoot from $8,000 to approximately $20,000. Hot money investors would’ve jumped in as the cryptocurrency rose to ride it up to its peak before promptly selling.
With this kind of strategy, investors must always keep an eye on the market to make sure that their investments are still going strong. Hot money requires active participation and surveillance of investments. These investors are ready to move their money elsewhere whenever it looks like their current investment will drop.
If investors decide to adopt the strategy, sound market knowledge and financial acumen are required. They must be able to apply trend analysis and quickly read market inputs.
Risks Involved in Hot Money
It is important to make sure that you know the risks involved with a hot money strategy. High rewards are not without high risk.
One risk in this type of strategy is volatility. By its very definition, hot money requires volatility in order to extract quick returns. A steady investment that is not moving will not generate the desired returns. The risk is that with the chance of a quick and large return, there is also the chance of a quick and large loss.
Another risk is that of transaction costs. These can often devour any potential returns when an investor engages in frequent trading. This is particularly apparent in stock portfolios, which involves fees for each trade. The investor must take care to ensure that their profits are sufficiently large to overcome transaction costs.
Factors that Influence the Strategy
Several market factors can influence investor returns from hot money. These factors often contribute to the volatility of the asset in question. If an investor can perfectly predict these factors, however, they can play the market and increase the value of their investments. Failing to take these factors into account, however, can lead to losses.
1. Exchange rate fluctuations
A common hot money vehicle is the purchase of esoteric currencies (such as in the case of Bitcoin or perhaps investing in the Thai baht), or mainstream currencies in the presence of uncertain market conditions.
2. Interest rates
Fluctuating interest rates obviously influence interest rate vehicles. Therefore, a hot money trader who invests in such vehicles needs to have firm knowledge regarding possible future interest rate movements.
3. Capital controls
In China, protectionary policies against foreign investments were implemented in recent years. The policies made it harder to engage in direct foreign investment in the Chinese capital market.
Investing in Hot Money
A hot money strategy is not for the risk-averse. Such investments require a great deal of market knowledge, sound financial acumen and, ultimately, luck. There are, however, certain steps an investor can take to increase their chances of generating high returns.
Conducting enough research
An investor should always perform as much research as possible. There is no downside to possessing more information, other than perhaps the effort required. Good information and research is often the difference between a smart trade and a reckless investment.
It’s good advice to start small with any new investing strategy. Doing so enables traders to get a feel for utilizing the strategy while avoiding potentially large losses. The more complex an investing strategy is, the more it requires practice to master.
Thank you for reading CFI’s explanation of hot money. CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep learning and advancing your career, check out the resources below: