The idea behind diversification is quite simple. It is the fundamental principle behind multi-asset investing (which 7IM is a firm believer in). Most investors have embraced it in one form or another – spreading your investments across companies, sectors and geographies reduces the likelihood of a one chance event affecting all of your holdings. An earthquake in California might hurt Silicon Valley-based tech stocks, but have no impact at all on German bonds, or the price of industrial copper.
The above appeals intuitively to almost everyone, and there are very few investors now, whether advised or independent, who own a concentrated portfolio of stocks. The famous exception is Warren Buffet, who calls the process “di-worse-ification” as it gets in the way of really getting to know a company’s merits. Having said that, even the Sage of Omaha admits that for 99.9% of people (ie. unless you are Warren Buffet), broad and cheap tracker funds are the best investment.
So far so good. Yet many investors overlook a major factor in their return –the impact of foreign currency exposure. It seems screamingly obvious, but in order to invest abroad, you have to convert your Sterling; before buying a share in a US company, you first need the dollars to do so!
Suddenly, along with exposure to the share price, there are changes in exchange rates to consider – something which hugely increases the complexity of a portfolio. Imagine owning a single UK company – let’s say Tesco. Adding a holding in something like BP means there are two sources of return, depending on the performance of the two shares. If we then add a position in Apple, we now have to consider the share price movements of the three stocks plus the movement in the dollar/sterling exchange rate. Buying another international equity such as Volkswagen (VW) adds another two moving parts to the equation – VW’s price plus the Euro movement.
Some academics argue that over time, currency fluctuations tend to even out, which may well be true over decades (although there is some doubt about even that broad a statement). In the real world though, failing to take currencies into account can change the whole perspective on whether an investment was successful or not.
Looking at Japan over recent years provides an excellent demonstration of the above. In December 2012, Shinzo Abe became prime minister, winning a landslide election on a platform of structural reform and economic growth. This was great for the equity market, with the Topix index of Japanese companies rising 70% over the following two years.
However, one of the stimulus measures that Mr Abe introduced was a loosening of monetary policy, which drastically weakened the Yen. For a Sterling investor, this meant that the 70% return was reduced to 27%. Over the same period, the FTSE 250 index of mid cap UK companies returned 37%. So a UK investor may have correctly identified the growth in the Japanese economy and invested accordingly, yet after adjusting for currency they would have been better off just buying their own local market!
Obviously, foreign currency can rise rather than fall too – over the course of the 2008 crisis, the Dollar rose by more than 30% against Sterling, so any US equities massively outperformed their UK equivalents.
The point of the above discussion is not to argue for or against foreign currency exposure – there is no consensus in the financial world as to the correct approach (arguably having the ability to do either is the ideal option). The main takeaway should be that when diversifying your investment portfolio, it is important to understand ALL of the additional risk that comes with such a move. Having an additional, ignored variable can turn good decisions into bad ones in a very short space of time.