When looking at stock market investment returns all is not as it initially seems. The returns of the separate funds within your personal portfolio can vary drastically from the actual returns of the underlying funds. This happens if your holdings are diversified; when you are invested in funds from different regions across the world. The main reason for the difference in performance is the impact of risk caused by the variations in global currency exchange rates and the portfolio’s asset allocation proportions.
Home bias is the tendency for investors in a particular country to favour and hold disproportionally more of their country’s stocks within their portfolio. One reason for this is that the investors are more familiar with local investments, therefore they feel that they have more control over how these investments perform. An example is a UK based investor who has a 60% allocation of their portfolio in stocks from the UK FTSE 100 companies. This is despite the fact that the UK economy is only about 4% on the global scale.
Such a disparity may mean that the investor will miss out on returns provided by investing in other world regions. An additional disadvantage is that such a portfolio will lack diversification and consequently will be more risky than a broadly based, globally diversified balanced portfolio. Volatility would be higher too, potentially leading to sleepless nights and increased likelihood of the investor making rash decisions.
Daily and longer term fluctuations of an investment portfolio are not simply based on the latest stock prices, but are also directly impacted by the movements of currency exchange rates. To illustrate this: if you are a UK based investor holding a fund of USA S&P 500 stocks, if stock prices on a particular day are unchanged but the US dollar gains 1% against the British pound your holdings would increase by 1%. This is because the currency used to hold the funds is the US dollar. These movements make it difficult to determine price movements over a particular time period.
Having the right attitude
So what is the solution to these potential problems. It really depends on your comfort level in terms of your home based holdings but it is recommended to diversify globally as much as possible. As I am based in the UK, I feel that a target allocation of 15% of UK stocks is preferable, together with all my fixed income allocation (20%) being entirely UK government bonds. The remaining 65% of the portfolio consists of foreign stocks which are held in various different currencies. Therefore 35% of the portfolio would be in funds based in pound sterling. This arrangement would alleviate much of the unpredictability caused by foreign currency movements and allow sufficient exposure to foreign stocks.
Having said this, currency risk is not necessarily a bad thing. If you hold mostly foreign stocks and you local currency depreciates heavily you could make big gains on you investments. A good recent example is what happened when the UK voted to leave the European Union (Brexit). Since the referendum vote in June 2016, the pound sterling lost its value by about 20%. At the same time a UK investor with foreign stocks saw super-sized gains of around the same proportion along with any “normal” capital gains and dividends.
The following data illustrates the impact of currency exchange rates on investment performance over a 3 year period for a UK based investor with holdings of foreign stocks (Vanguard US Equity Index Fund) and local stocks (FTSE 100). Over the last 3 years the British pound has depreciated against the US dollar as shown here.
The following chart shows the investor’s portfolio performance when viewed in US dollar terms. This would be the same point of view for US based investors. Gains of nearly 30% for the US fund and losses of nearly -20% are observed for the UK fund.
For comparison, the currency is switched to British pounds to determine how the UK based investor would have fared. A glance at the chart below shows a dramatic difference. Performance of the US fund would be almost 75%! Instead of a loss the UK fund would be in positive territory. This shows what an impact currency can have on investments.
However, it should be noted that the investor will find it more expensive in future to buy foreign stocks due to the investor’s local currency having lower purchasing power.
In the long run, I think a long term investor should not worry about currency risk. Currency movements are generally not too drastic and tend to balance out over the years. It is more important to have the right asset allocation, diversify accordingly, rebalance the portfolio when needed and avoid consuming too much financial news. These simple steps along with investing in broad based low cost index funds will certainly be a path to wealth and financial independence.
Currency data supplied by xe.com and fund performance data by morningstar.com