When at conferences or simply speaking with investment-minded friends, I’m often asked, “So why would I ever invest in currencies?” The idea of investing in foreign currencies seems foreign to many, especially if they aren’t crossing borders or working in global business on a regular basis. But changes in exchange rates impact us all every day, and we all have the potential to benefit financially from such changes. In this initial post on diversifying in currencies, we’ll get down to the basics, and then we’ll follow it up next month with some working examples.
After World War II, the price of exchange between most major currencies was managed by governments as outlined in what is known as the Bretton Woods Agreement (much like the Chinese government manages it’s own currency exchange rate today). However, in 1971, the United States unilaterally terminated the convertibility of U.S. dollars into gold, effectively dissolving the agreement. And since that time, the vast majority of the currency exchange rates from major economies have been determined in the freely traded marketplace.
Foreign exchange trading has often been cited as the largest financial marketplace as measured by daily volume. This is because there are many participants: corporations undertaking exports or imports; governments intervening in the marketplace; institutional and individual investment flows; traders; and personal currency transactions. It is this back and forth of practical and opinion based trades that set the price each day.
GETTING DOWN TO PORTFOLIO BASICS
Adding a particular asset class or asset into a portfolio is all about balancing the risk of loss against potential return. Neither of these can be known in advance, and they are nearly impossible to assess accurately prior to making a decision. According to many experts, including several Nobel Prize winners, creating a successful portfolio is all about diversification. Typical portfolios for a U.S. investor often include U.S. stocks, global stocks, U.S. bonds, real estate, and cash.
While, naturally, you want every asset in your portfolio to gain in value all the time – what you’re ultimately striving for is balance. A brief, high-level summary of the theories around diversification suggest that for any asset class or individual asset to benefit a portfolio, it should:
- Carry the potential for return. It seems simple, but there is no reason to add something with no source of return.
- Add a new dimension of return. For example, if Stock A has the same percentage change up or down as Stock B – or at least highly similar – then it does not add any diversification to a portfolio. Bottom line: if it has similar price fluctuations to another stock one owns, then there is no point in adding it to a portfolio.
Since 1971, researchers and advisors have studied many of the characteristics of currencies as an asset class. One of their conclusions was that currencies could add diversification to an investment portfolio and thus help to lower the overall risk in a portfolio. In general, currencies have the potential for return and have a low correlation with other typical asset classes1 held by U.S. investors, thus meeting the two high-level criteria of diversification.
Like all asset classes, currencies move up and down with the market. Different from the stock market, where equities go up or down depending mostly on the market’s assessment of future earning power, currencies change prices mostly as a matter of relative comparison, or, more specifically, how does one country’s situation look compared to another.
In making this assessment, we tend to look at a number of different factors, and typically do so by employing the blanket caveat of ‘all other things being equal’ - i.e., if all other variables are equal, a change in X will create a change in the value of Z. While this never really plays out in the real world, it does provide us with a sound starting point when weighing the potential for one currency against another.
FIVE FACTORS WORTHY OF COMPARISON
Here are five of the factors that many experts will consider when assessing a currency:
- The relative overall economic health of the two countries in question.
- The relative condition of fiscal policy. If Country A is running a significant budget deficit compared to Country B then that deficit will tend to depress the value of Country A with the higher deficit.
- Relative monetary policy. If all other things are equal, a fast increase in the money supply of one country (C) versus another (D) will require that the price of the currency from the country with the faster growing money supply will decline, in this case, Country C’s price will decline.
- Relative trade situation. Running a trade surplus at all is generally a good thing for a currency, and running a larger trade surplus than another country is also better.
- Flight to quality. In difficult times or times of outright crisis, many global investors will place funds in a currency that is simply seen to be “strong”. For many years the U.S. has filled that role as the country with open markets, strong financial backing, and substantially maintaining rule of law.
So that concludes part 1 of this post on diversifying in currencies. Next month, we’ll conclude Currency Investing 101 with an informative earnings example, as well as more insights on the potential value currencies could hold inside your portfolio.