I came across this Telegraph article the other day and it reminded me of one of a common mistakes investors make: not taking currency risk seriously. If you haven’t read my post on Base Currency, I suggest you do before we go any further.
I’m sorry to single them out, but Japanese investors fall into this trap all too often. With interests rates at zero for so many years, Japanese investors are hungry for yield. This leads them to buy overseas bonds or cash deposits that are paying high interest rates whilst disregarding the risk that currency fluctuations might go against them. New Zealand dollars were a favourite for a while, then Australian bonds, even Latin American debt was popular at one point. The chart below (from Trading Economics) showing Brazilian Real vs Japanese Yen tells you all you need to know about this trade: regardless of the interest rate you receive, if you bought 10 years ago and held until now you have lost almost half of your money on the currency conversion…
Going back to the Telegraph article, currency fluctuations can, of course, work in your favour as well. UK investors holding overseas assets have seen their returns magnified by the fall in the pound since the Brexit vote. Japanese investors who bought foreign assets during the period of JPY strength from 2011 – 2013 will also have benefitted as the yen weakened.
So how do we mitigate currency risk, whilst retaining some of the advantages of investing in other currencies?
Know your base currency – this is the currency you are planning to spend the money in. Remember you may have different base currencies for different financial goals.
Invest in a globally diversified portfolio – exposure to overseas assets is important, however keep the majority of your portfolio weighted to your base currency. A well constructed growth portfolio will be between 65-85% invested in base currency assets.
Know your time horizon – the closer you are to spending the money, (eg. retirement) the less you can afford currency risk.
If you are going to take currency risk, be smart about it – make sure you have understood historical exchange rates and know where you are in the cycle. If a currency is at historical highs it is likely to return to the mean at some point, but be very careful about betting on the timing. Remember the famous quote from John Maynard Keynes:
“Markets can remain irrational longer than you can remain solvent.”