The Role of Currency Risk in Internationally Diversifying Your Portfolio
In recent years, we have experienced a lot of inflation due to political and economic tension. Some currencies had more inflation, others less. The U.S. economy and dollar had 9.1% inflation in 2022, whereas the Swiss franc never had more than 3.6%. The U.S. population has seen the dollar lose quite a bit of its purchasing power during this time. Further, the U.S. dollar started 2022 strong and gained in value to a basket of currencies but did not maintain its strength, losing much of its gained value by year's end. While these numbers do not tell the entire story, they do paint an interesting picture of how currencies fluctuate in value. One way to combat this loss in value for American investors is to diversify into other currencies. However, investors who hold multiple currencies can be exposed to currency risk when exchanging one currency for another. But what is a currency risk exactly, and is it only a negative?
Definition of Currency Risk
Currency risk, also known as exchange rate risk or foreign exchange risk, refers to the potential financial loss that can occur due to fluctuations in exchange rates between different currencies. It arises when an individual, business, or investor is exposed to the possibility of adverse movements in currency exchange rates, which can impact the value of their investments, assets, liabilities, or income both positively and negatively.1
Currency risk can affect various entities engaged in international transactions, such as importers, exporters, multinational corporations, investors with foreign holdings, and travelers. Fluctuations in exchange rates can lead to gains or losses when converting one currency to another, impacting the purchasing power and profitability of transactions involving the trading of various legal tenders.
Currency Diversification
What you have to know if you hold--or are thinking about holding--different currencies is that converting between currencies often incurs transaction costs, including fees and exchange rate spreads. If you already own the money, you don't suffer from the fees and exchange rate spreads. However, when trading currencies as an investor, it is important to consider the fees as they will weigh into performance from one currency to another.
It might be assumed to avoid currency risk negatively impacting you, it's better not to hold foreign currencies, but this risk also holds an opportunity for investors, diversification. Diversification is the practice of spreading your investments around so that your exposure to any one type of asset is limited, or in this case, currencies. This practice is designed to help reduce the volatility of your portfolio over time.2 The principle of diversification can also be applied by holding different currencies. By spreading your holdings across multiple currencies, you're able to reduce the risk of fluctuations in the value of a single currency.
As a result, it has the potential to help protect your wealth from the impact of currency devaluations, economic crises, or geopolitical events that affect a specific country and its currency. A simple example is when a country experiences high inflation that affects the purchasing power of a country's currency. The U.S. saw high inflation of 9.1% high in 2022. While still high, Switzerland saw lower inflation of 3.5% in 2022. Both countries' currencies experienced the impact of loss in value to their currency, but Switzerland saw much less. If we look at the long-term numbers, the U.S. dollar (USD) has been losing value significantly over the past few decades. The chart below gives a great visual of the loss in value the USD has experienced over the last 50 years.3
At the start of 1972, you could buy nearly 4 Swiss francs (CHF) with $1; at the end of 2022, if you exchange $1, you could get CHF 0.92. The Swiss franc has become more valuable than the USD over the long term. So if you only held USD in cash over the last 50 years and you would have missed the opportunity to reap the benefit of the appreciating CHF against the USD while the USD was losing 86% of its value. It is a clear picture of how the USD has lost value not only in its value in and of itself but has lost value against other currencies, like the CHF, over time. While less pronounced, the USD has continued its historical downward trend in the long term.
Another example of pressure put on the value of the USD currently is that the BRICS countries (Brazil, Russia, India, China, and South Africa) have been in talks to create another currency so that they don’t have to trade oil in dollars anymore.4 In fact, it is already happening in India, where they use rupees to trade non-oil commodities. China, for example, has been trying over the years to trade oil in its own currency, and some oil-trading countries are beginning to consider it. For more on this, read: The Impact of the China-Arab Summit on the U.S. Dollar. With these events in mind, the USD does fall under a bit of pressure. Diversifying your portfolio can be an option to help Americans lower the impact of the volatility of the USD value. Otherwise, the potential devaluation of the USD could further impact hard-earned wealth.
It is important to note different currencies may exhibit other levels of volatility and returns, and there it is always recommended to speak with a professional before making any investment decision. All investments come with risk, and holding foreign currencies does as well. Make sure to find a specialist with experience and expertise in the area of international diversification and foreign currencies before making any decision.
Risks
As mentioned above, holding currencies other than your domestic currency can come with several risks.
Exchange rates between currencies can fluctuate significantly due to various factors such as economic indicators, political events, and market sentiment. If the value of the foreign currency you hold depreciates against your domestic currency, you may experience a loss when converting it back.
Depending on the law in your country, there could be some restrictions or regulations on holding foreign currencies. It’s important to be aware of any legal requirements or limitations before adding foreign currencies to the portfolio. A current example is trading and using Russian Rubles is not allowed due to the current sanctions in place.
Another risk is that not all currencies have the same level of liquidity, in other words, their ability to be bought and sold easily. Some currencies are less traded than others, which can make it difficult to convert them back to your domestic currency when you need to. Therefore, they also have a wider bid-ask spread, resulting in higher transaction costs.
The central bank of different countries adjusts their interest rates to manage their economies. Variations in interest rates can affect the valuations of the currency.
To sum it up, currency risk plays a crucial role in internationally diversifying your portfolio and can offer your opportunities as an investor. If you invest in foreign currency, you expose yourself to the potential impact of fluctuations in exchange rates, both negatively and positively. This is the reason that it is important you work with professionals to help you make informed decisions when diversifying your portfolio. While international investments offer opportunities for capital preservation, returns, and diversification, it can`t be ignored the impact of exchange rate movements on investments.
If you are interested in contacting us with your questions on how we help people move out of the USD and diversify their portfolio, you can contact us through the link here: https://whvp.ch/contact-connect/connect
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