Geographic diversification of your portfolio is key when it comes to managing risk and seeking return. However, while there are advantages to investing beyond our borders, currency risk (or “exchange-rate risk”) can affect your portfolio’s returns—especially in the short term. That’s why it’s important to understand what drives currency risk and how it impacts the value of your investments.
There’s more to foreign investments than picking stocks
Any portfolio with foreign investments results in foreign currency exposure. For instance, all of MD’s investment portfolio recommendations beyond a three-year time horizon include foreign investments. Geographic diversification is essential to reduce risk and optimize return. Yet, many investors focus solely on the stock decisions in their portfolio and overlook the important contribution from currencies.
When you invest in foreign securities, changes in exchange rates can affect your investments, such as a mutual fund that holds U.S. or international stocks. Fluctuations in the value of the Canadian dollar relative to any foreign currency can affect the value of your investment, either positively or negatively. For instance, when the Canadian dollar rises relative to a foreign currency, it results in a lower valuation of a foreign investment when measured in Canadian dollars. Conversely, when our dollar decreases relative to a foreign currency, it results in a higher valuation of a foreign investment when measured in Canadian dollars.
Currency’s effect on returns over time
While many studies conclude that currency returns are expected to be negligible in the long run, plenty of evidence exists to suggest that in the short to medium term, currency exposure can have a significant impact on investors’ international portfolios. As Chart 1 shows, while the impact of currency returns as a percentage of total portfolio returns can fluctuate, over time its effects are minimal.
Chart 2 further illustrates the significant short-term impact of currencies. The orange line represents the rolling one-year change in the CAD/USD exchange rate, while the green line represents the rolling 10-year change. On a rolling one-year basis, volatility in the CAD/USD exchange rate has been substantial, especially during the global financial crisis of 2008–09 when the CAD/USD exchange rate fluctuated between -20% and +25%. Meanwhile, the rolling 10-year CAD/USD exchange rate has been much less volatile, fluctuating between –5% and +5%. While evidence shows that currency fluctuations in the long run are muted, short-term volatility can be substantial.
Chart 2 Title: Short-Term Currency Impacts Can Be Substantial
Need more information?
Geographic diversification is certainly essential but, as we’ve seen, having an active currency management strategy in place is imperative when investing internationally. Learn more about how professional financial advisors, such as MD, manage currency risk for investors.
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