I don’t need to tell you the world is a big place. But I do need to remind you that when you are considering the makeup of your investment portfolio you need to consider where in the world your investments are, and how the location of your investments can affect the returns you may receive over time.
Reading a lot of investment commentary coming out of America, investors in the States typically have a large proportion of their investments in the US stock market.
It is for a good reason.
The US stock market is the largest in the world and has some very strong performing companies. For an American investor they can invest exclusively in the US stock market and can build a well-diversified portfolio that is likely to perform well over the long term. Even so, many investment advisers recommend a small proportion of ‘International’ exposure for added diversification and are lured by the potential of extra returns by hoping on rapid growth in emerging markets. However, advisers often caution having too much exposure to international stocks because of the added risk of ‘currency risk’.
What is currency risk?
Currency risk is the potential risk of loss from fluctuating foreign exchange rates when an investor has exposure to foreign currency or foreign-currency-traded investments.
For example, I’m in the UK. If I bought an American investment that traded in dollars, say $100. I would need to convert my pounds into dollars to buy the investment (currently £70).
Let’s imagine I got a great return of 100% and doubled my money, so my American investment is now worth $200. In order to cash out and spend my return I would need to sell the investment and then convert the dollars back into pounds. If the exchange rate had stayed the same, the $200 would now be worth £140 (70*2).
However, if the pound/dollar ratio had changed, my return on my investment would be different. Perhaps $200 could only buy me £60 in the future?
Currencies ‘strengthen’ and ‘weaken’ against other currencies all the time in response to economic forces.
This means that when you invest in stocks and shares that trade in different currencies, your portfolio not only has market risk (the company could lose value), but also you have to consider currency risk (your home currency might not be able to buy as much foreign currency as before).
If you are a UK investor or investor in a smaller market than the US, you do not have the luxury of avoiding currency risk as our markets are relatively small compared with America and to provide good diversification, international stocks might take up a bigger proportion of a typical investment portfolio.
Some investors mitigate perceived currency risks using financial instruments that move in the opposite direction to currency fluctuations, but this is only really worthwhile in very large portfolios with significant international exposure. For bigger investors there are also companies such as Sucden Financial who provide foreign exchange to companies needing to hedge their currency risk and to help with liquidity.
The good news is over the long term, the markets tend to self-regulate when it comes to currency fluctuations as the very presence of currency risk can create an opportunity for investors who follow the interest rates between two countries and the relationship to exchange rates. For example, if interest rates are higher in the UK, other currencies are likely to fall in value relative to the British pound as when interest rates increase in a particular country, international currencies flow into that country to take advantage of the higher yields. This pushes the value of that country’s currency higher.
Certainly the world is a big place, but we are more connected than ever before and financial ripples in one market can reach another. Understand the types and level of risk in your portfolio to be a better prepared and informed investor.