As we saw in "Investing Abroad," investors have a home bias. That is, they tend to invest much more in their home assets than advised by the most advanced financial models. Consequently, the average investors' portfolio tends to have high risk and low returns. Much of the same happens for currencies. Investors present a strong home currency bias (Maggiori et al, 2019), which increases their short-term risks. In periods of crisis, local currencies often fall leading to massive losses in wealth. From 2007 and to 2010, for example, the U.S. median wealth dropped 44%, to a large extent, due to American citizens' lack of investment diversification across multiple currencies and different asset types (Wolff, 2017). In fact, the American median wealth was lower in 2010 than in 1969 after accounting for inflation.
Investing in assets denominated in multiple currencies
Long term exchange rate fluctuations are highly correlated with inflation and currency hedging in the long term makes little sense. On the other hand, short term currency fluctuations are highly speculative (Siegel, 1994). Too many factors can have a significant influence in exchange rates in the short term such as interest rate changes (or expectations), central bank policy (like forward guidance), trade balances, international capital movements, relative growth rates of demand and GDP in each economy. Therefore, currency exchanges are very hard, if not impossible, to predict in the short term. The problem is that we all need to use some type of currency in our everyday life and consequently, you are "betting" on them. Even if you have all
your investments are denominated in your home currency, you are hoping that your currency will appreciate or at least do not devalue. All currencies, including strong ones (e.g. dollar, euro, pound, yen, franc) often lose a significant part of their value in world markets and it is important to protect yourself against such devaluations. From 2014 to 2015, for example, the Euro lost more than 25% of its value against the US dollar. From 2005 to 2015, the US dollar lost more than 30% against the Chinese Yuan. In August 2019, the Argentinian peso lost 30% against most currencies in one single day! In other words, if a European needed 100 thousand euros in 2013 to do a master's degree in the US and they had all this capital saved in euro, they will need to spend an extra 25 thousand euros to do the same degree in 2015. If this person had part of their saving denominated in simple dollar-denominated bonds this currency fluctuation problem could have been easily avoided. Similarly, if you were an Argentinian looking to make a tourist trip to Brazil in July 2019 but you procrastinated for a month you probably will not be able to make this trip anymore since the overall price of travel is now 30%+ more expensive. This is why we usually recommend our client to diversify their investments in assets denominated in multiple currencies, especially if they have or expect to have expenses in other currencies in the next couple of months or years. (Graphs 1-5 show multiple recent examples of major currency devaluations). Furthermore, Argentina did not become a 30% worse place for tourists or digital nomads to live in 24 hours in August 2019. Nor did the Eurozone became a 25% worse place than the US to visit between 2014-2015. These major short term currency fluctuations can create bargains for flexible travelers looking to visit, study, or live in other countries.
Investments denominated in foreign currencies can protect against these currency devaluations since a drop in the value of your home currency can be neutralized by currency stability in other markets. Additionally, stocks can systematically lose value throughout the world (at least in theory) but exchange rates are relative. For example, if the US dollar is depreciating against the Brazilian real that necessarily means that the Brazilian real is appreciating against the dollar. Thus, if you are Brazilian and you are thinking about traveling or studying in the US soon, you have strong incentives to buy dollar-denominated investments just in case your home currency falls. The same goes for Americans thinking to go to Europe or Europeans planning a trip to Latin America. In finance this operation is known as "hedge," but it is usually done in an inefficient way of buying a currency that does not allow for further investments and also includes significant fees (such as through foreign exchange market). In this case, the currency will be the investment itself and currencies tend to greatly underperform other asset classes such as stocks and bonds in the long term.
On the other hand, if you have a bank or brokerage firm abroad you can invest your foreign currencies in other investments, like stocks. Since stocks and exchange rates are not well correlated in the short term you can potentially gain with the appreciation of the foreign currency plus the stock or bond growth. For example, news that brings optimism about future economic growth can increase stock values and appreciate the local currency (Siegel, 1994). Bonds denominated in foreign currencies sometimes give more than 20% in annual returns and are not well correlated with inflation or exchange rates in the short term, potentially decreasing the risk of a portfolio.
Graph 1. Japanese Yen and the Euro lost 35% and 25% of their value, respectively, against the US dollar between 2012 and 2015
Graph 2. US dollar lost almost 30% of its value against the Chinese Yuan Renminbi between 2005 and 2015
Graph 3. US dollar lost half of its value against the South Korean Won between 1997 and 2007
Graph 4. Brazilian Real lost 83% of its value against the US Dollar between 1994 and 2019
Graph 5. British Pound lost about 40% of its value against the US Dollar between 2008 and 2017
Obviously, there are also risks involved as the foreign currency can depreciate. However, the more currencies you have the volatility of your portfolio return will be because different currencies have different patterns. In other words, if you have a basket of currencies, the risk you suffer losses from fluctuations in exchange rates will be smaller. Additionally, although rich countries' currencies can have major fluctuations, emerging market currencies tend to have even stronger fluctuations. Therefore, residents of developing countries have more to gain by buying rich countries' currencies (in terms of risk management) than vice-versa.
I never or rarely leave my home country. Why should I care for currency risks?
Most developing countries and even many developed countries trade in dollars. For example, although only roughly 20% of the exports of Thailand and South Korea go to the US, 80% of their trade is invoiced in US dollars. Similarly, less than 10% of Australian trade goes to the US but 70% of its exports are set up in US dollars. 85% of the total foreign exchange transactions are made in US dollars, which is clearly the most important currency in the world (Eichengreen, 2011). A far distant second most important currency in the globe is the euro. For obvious reasons, the price fluctuation in response to changes in the exchange rate is significantly affected by whether your country's currency is used in international trade transactions. That is if the imports in your country are mostly denominated in the US dollar and your currency suddenly depreciates 30% against the dollar, then the price of the imports will increase by 30%. However, your salary is unlike to increase by 30% in a few days, like the 30% drop in the value of the Argentinian peso in 2019 (due to surprising political results) or the 25% depreciation of the Brazilian real in 2020 (due to the coronavirus crisis). Thus, although you never left your home, your money can suddenly buy much fewer goods than before.
The main idea is, if all your investments are denominated in your home currency and it drops against the denomination of import you consume, your purchasing power will decrease. In other words, currency fluctuations can not only make international travel much more expensive but also make your money worth less in your home country, even if you never leave your hometown. This is the reason why is so important to have part of your capital invested in liquid assets denominated in foreign currencies, especially the US dollar (like the TIPS ETF). Conversely, local currency shocks will lead to much weaker price changes in a country that trades with its own currency like the US, where 90% of its imports are price in local currency. Overall, in a few rich countries, consumer price fluctuations tend to be relatively minor for small to modest exchange rate changes, i.e. their exchange-rate pass-through is lower (Burstein and Gopinath, 2014; Gopinath et al, 2010).
- Burstein, Ariel, and Gita Gopinath (2014). “International Prices and Exchange Rates.” Handbook of International Economics, 4th ed., 4: 391-451.
- Eichengreen, Barry (2011). Exorbitant privilege: the rise and fall of the dollar and the future of the international monetary system. Oxford: Oxford University Press.
- Gopinath, Gita, Oleg Itskhoki and Roberto Rigobon (2010). "Currency Choice and Exchange Rate Pass-Through," American Economic Review, American Economic Association, vol. 100(1), pages 304-336.
- Maggiori, Matteo, Brent Neiman and Jesse Schreger (2019). "International Currencies and Capital Allocation," NBER Working Papers 24673, National Bureau of Economic Research, Inc.
- Siegel, Jeremy (1994). Stocks for the long run: the definitive guide to financial market returns and long-term investment strategies. New York: McGraw-Hill.
- Wolff, Edward N (2017). “Household Wealth Trends in the United States, 1962 to 2016: Has Middle Class Wealth Recovered?” NBER Working Paper No. 24085.
IMPORTANT: THERE IS NO ONE BEST TAX OR INVESTMENT STRATEGY. IT ALL DEPENDS ON YOUR GOALS, RESOURCES, AND CITIZENSHIP.
For example, are you willing to move abroad? If so, where? How long do want to stay in each place? What is your annual income? How much money are you willing to invest? Do you want short term gains or long-term investments? What is (are) the source(s) of your income? How much taxes do you pay annually? Do you want to decrease your tax duties or completely remove them? Do you feel like you want to pay some taxes even if you do not need to? What is your citizenship? Do you have multiple citizenships? Depending on each of these answers the best investment/tax strategy for you will differ. In order to see what option is best for you and to help with the implementation of the strategy feel free to reach out to us. You do not need to be rich to create a global investment portfolio. Most of the bank and brokerage accounts we open do not have minimum initial deposit or maintenance fee. Thus, you can invest as much as you want or even leave the accounts empty until you have enough capital or interest to invest abroad.