Ignore currencies at your peril

John Osbon - October 31, 2012

Many US investors are just that: they invest mostly in US stocks and bonds.  But many also diversify their investments outside our borders, buying securities domiciled in other countries, and denominated in their respective currencies. What are the risks related to international investments, and are they worth it?

Dollar, volatility is thy name

What is a dollar worth? How about the pound? Well, the answer changes every minute. Just take a look at the dollar chart below to get an idea of its rollercoaster ride over the last five years. This index tracks the dollar against a diversified basket of currencies. The index has leapt and tumbled, experiencing swings of 10-20 percent in most years.

Five year dollar index. Click for larger image. Source: Finviz.com

Individual currency exchange rates, like the euro versus the dollar (below), are typically even more volatile than a mix of currencies.

Five year euro vs. dollar. Click for larger image. Source: Finviz.com

These graphs, in my view, tell two important stories:

1)    Beware direct investment in currencies – In general I do not recommend that individual investors buy euros, yen, or any other currencies. The daily currency trading market is estimated at $4 trillion, dwarfing all other markets. It’s almost all institutional money, and I see no reason to think that an individual can outthink all those professional traders. You may get lucky and guess right, but it’s like betting on coin flips – your expected return in the long term is zero, before transaction costs.

2)    Recognize the risk in foreign stocks and bonds – Currency movements add an extra layer of risk to any investment in non-dollar securities. If you own stock in a German bridge builder, for instance, your total return will depend not only on the competitive performance and management of that business, but also on the relative strength of the dollar and the euro. A strengthening dollar against the euro, for example, reduces the return for dollar-based investors. Be sure you understand the currency risk element before flooding your portfolio with non-dollar investments.

The role of non-dollar investments

Of course foreign investments do have an important role in building a portfolio. They add diversification. In many economic and political environments, we expect Japanese, Chinese or Brazilian securities to behave differently than US investments. The question is how much exposure you want or need to these different economies (and the associated risk related to exchange rates). That answer is different for every investor.

In my experience, many investors do not have a very good handle on how much exposure they have to currency fluctuations. When we conduct a portfolio analysis with a new client, we begin with a couple fundamental graphs, including one that reveals international exposure. (Read our recent post, “The big picture, literally”)

Currency matters

What should you do about currency effect in your portfolio?  My advice is to be aware and be deliberate. Currency risk is definitely not something that will just go away if you ignore it. Understand your exposure and make decisions accordingly. Currency risk is one big reason we emphasize and use the “portfolio picture” for Osbon Capital clients.

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