Fretting Over Currencies?

If a relative, neighbor, or colleague asked me how to manage currency, I would tell her the same thing--don't bother.

Currency moves can be maddeningly random, reflecting the cold-blooded efficiency of the global foreign-exchange market. Without a real edge, most currency investors, including the vast majority of professionals, are likely to flounder.

Sobering, maybe, but that's the practical reality.

But the broader backdrop is also worth considering. Namely, we wouldn't be having the currency conversation if not for the fact that something had already happened.

Recently, that "something" has been the underperformance of foreign-currency-denominated investments. Although the dollar has pulled back over the last couple of months, it has still enjoyed a strong rally over the last year. Meanwhile foreign-currency-denominated investments languished versus the greenback amid concerns about growth abroad and the specter of competitive debasement. In other words, currency has, until recently, gone against some investors, and now they want to avoid a repeat.

But let's try to unpack the assumptions laced through that thinking:

• Past is prologue (it's going to keep happening).
• Foreign currency is a material exposure (it's big when measured in anticipated local-currency-denominated spending terms).
• Foreign currency is a material exposure for fundamentally justifiable reasons (it's not big because we were originally afraid of what might happen to the U.S. dollar or stocks).

The recent pullback notwithstanding, let's assume past is prologue and the U.S. dollar continues to rally. Does the story just end there? In that scenario, dollar-denominated wares become progressively more expensive abroad. Conversely, foreign-sourced goods and services get cheaper in dollar terms, which, in turn, can create the stirrings for economic demand (as foreign operators crank up hiring or make investments in plant and property). As that happens, disinflationary pressures begin to ebb, allaying concerns about a continued downward spiral, which was one of the original catalysts for non-U.S. currencies' downward move after all.

Don't get me wrong--if currency markets moved that predictably, then I wouldn't caution anyone against tinkering with their currency allocations in the first place.

Rather, the currency market dances to its own rhythm. The point is that currencies tend to seesaw against each other in the normal course, those leadership changes reflecting the interplay of complex macroeconomic factors that can dart and dive against each other in finding equilibrium.

No Easy Fix We also have to ask ourselves if foreign currency really is a material exposure. Does it represent a big chunk of our near-term local-currency-denominated spending? Or is it immaterial, practically speaking, because most of that foreign-currency exposure is in qualified accounts that aren't going to be touched for a while anyway?

In the unlikely event that our spending is being funded with nondollar assets, then, yes, we'd want to ensure our currency exposures haven't thrown us off balance. But, if not, then it probably makes more sense to ask whether foreign-currency weakness is a fleeting issue or a more intractable problem (hint: think fleeting, for some of the same reasons mentioned earlier).

But for discussion's sake, let's assume currency really is material. At that point, the question becomes why. Is there a fundamentally defensible reason for allocating our assets that way?

For many investors, including those who shifted assets toward shorter-duration, foreign-currency-denominated instruments out of fear the U.S. Federal Reserve would print the dollar into oblivion or that U.S. stocks and bonds would crater, I suspect the answer is no. These investors acted largely on emotion, incurring a steep opportunity cost in the process, and then faced a quandary--sell outright (or fully hedge) to make the pain go away, or live with it in the hope that performance will rebound. There's no easy fix.

There are several relatively simple, common-sense approaches to managing one's currency exposure, which can be done via low-cost, highly transparent, and flexible vehicles like exchange-traded funds and pursuant to a suitable, long-term investing plan. But even the most prudently constructed, inexpensive, easy-to-maneuver financial product isn't going to save you from yourself if you act on short-term, instant-gratification impulses.

What I'm arguing for is a little perspective. Short-term currency moves probably aren't going to make or break us within the context of a widely diversified portfolio for a few reasons.

First, they often wash out, for some of the reasons noted above but also because a portfolio spread across multinational companies and issuers is going to naturally encompass the offsetting effects of multiple currencies (as those firms and issuers do business in a number of locales).

Second, provided we've plowed an appropriate portion of our portfolio into stocks, currency impacts likely aren't going to be a big deal over the long haul.

What Buffett Says But don't take my word for it: Here's Berkshire Hathaway chairman and CEO Warren Buffett in his 2014 letter to shareholders:

"It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash-equivalents. That is relevant to certain investors--say, investment banks--whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.

"For the great majority of investors, however, who can--and should--invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities."

Buffett is warning investors about two things.

First, the illusory "safety" of holding cash over long time horizons, a point he reinforces by noting elsewhere in the letter that while the S&P 500 had risen nearly 11,200% (with dividends reinvested) over Berkshire's 50-year history, the dollar had lost 87% of its purchasing power over that span. Second, mistaking volatility for risk, which he defines as a loss of purchasing power during one's lifetime. That lesson was likely lost on investors who fled U.S. stocks for the perceived safety of short-term, dollar- and nondollar-denominated instruments a few years ago.

In other words, more often than not we make currency an issue through our actions (catalyzed by emotion).

So, tempting as it might seem to try to manicure our portfolio's currency exposures to achieve a particular end, we'd probably be better off asking more fundamental questions about what our goals are and whether we've structured our portfolios accordingly.

This article originally appeared in the April/May 2015 issue of Morningstar magazine.