What if there was a bet in your portfolio that you had no idea you were making?
You may believe that your foreign stocks are doing well, but those high returns might be from something else. There may be another exposure unbeknownst to you in your portfolio; it could help or hurt you, and you need to know what it is.
When it comes to investing, U.S. stocks are easy. Investing in foreign stocks? Much more complex.
When you invest in foreign stock, you are not just investing in the company; you are also investing in the currency of that country. It may be just buying one stock, but you technically have two investments going.
Here’s an example. You have invested in Sony, a Japanese company. While invested, their stock goes down, but when you sell you find that you’ve made a 10% return. Why did this happen? Because the yen appreciated during that time period. Sony might have gone down 5%, but the yen appreciated the value of that stock, and any other Japanese stock you may own, by 15%.
The same thing could happen vice versa. A thriving stock may be brought down by depreciating currency, or a poorly performing stock could be hidden by the increasing value of the currency. There is more than one number at play.
The way the US dollar trades compared to the Japanese yen is as much of a bet as buying one stock versus another. And what’s amazing is that the relationship between the dollar and yen goes in waves. There are times when people think their foreign stocks are doing really well, but in reality it’s the currency that is driving the return.
How has this played out in the past? Let’s take a look at 1995 to 2002, when the dollar declined in value. When the dollar declines in value it can help your foreign stock exposure quite a bit, and most of the gain may be in currency.
A few years ago we saw foreign stocks going nowhere. But everyone living in the USA thought their foreign stocks were doing great. What actually happened is the currency part of the equation above was doing well because the value of the dollar was falling. Foreign stocks (as measured by MSCI EAFE) had a 55% return from April 2002 to December 2011. 54% of that return was due to currency! The stocks themselves? They performed horribly.
Diversification across borders makes sense as sometimes the US stocks will out perform the market, and sometimes foreign stocks will. As you look to foreign stock exposure and past returns, you need to ask the follow-up questions—How much of the return is due to currency and how much is actual stock performance?