Understanding Currency Risk

This is a very real risk for most Americans, but it's one that receives little attention. If you live in the US, you pay virtually all your bills with US dollars. Many people forget to consider, however, that over half the goods we buy on a daily basis are imported. We import everything from fruit and vegetables to clothing, electronics and automobiles. This means that, while we may pay for them in US dollars, the company that imported them needs to pay in the currency in use where the goods originated. If the dollar drops in value, the cost of many of the goods we purchase every day goes up in lockstep with that drop. If the dollar were to increase relative to other currencies, then we'd find imported goods more affordable, however, we'd also find that any foreign investments we own would suddenly decrease in a similar proportion.

Currency risk is even more prevalent when it comes to investing. Virtually all investments are denominated in the currency of the country that issued them. Thus Japanese stocks must be paid for in yen and European stocks must be paid for in euros. Likewise, when these investments are sold, we're paid in that same foreign currency. Mutual funds can seriously confuse this subject and lead investors to miss out on this crucial element of risk. There are approximately 50,000 mutual funds for sale in America. The vast majority of these are denominated in dollars. When we buy a European or other foreign mutual fund and pay in dollars, it's easy to forget about the currency risk, however, just because we forget, doesn't mean that the risk ceases to exist. When you purchase that fund, the manager must immediately convert your money to euros or yen or drachmas-whatever. He does this so that he can purchase the required investments, because of course he has to pay in the local currency. If you purchase a European mutual fund and the fund does well, will making a profit of fifteen percent make you money? It depends on what the currency does. If the euro drops by twenty percent over that period, then you will have made fifteen percent on the investment, but lost twenty percent on the currency, for a net loss of five percent.

Currency risks are very real, but fortunately they can be effectively managed. The easiest way to manage this risk is to keep the majority of your investments in the currency that you use to make the majority of your purchases. If you live in the US, you'd want to have at least sixty percent of your investment portfolio in dollars. What do you do if you dream of retiring to Italy? Increase the euro component of your portfolio in proportion to the amount of your income that you plan to spend in the Europe each year.

The remaining currency risk can be diversified away. Remember that currencies are a zero-sum game. This means that every currency can't drop in value and every currency can't gain. If you looked at the exchange rates of all world currencies (a huge job, I assure you), you'd find that the average value is always the same. In other words, for the US dollar to gain one percent in value, there has to be a corresponding drop in value in the currency of some other country or combination of countries. If your investment portfolio contains the right amounts of several different currencies, you'll find that any drop in one, will be compensated for by a rise in another. Thus, currency risk can be reduced or even eliminated.