Why currency matters when you invest globally

When you hold a share that is listed in a different currency from your own, your return has two parts: how the share price moves in its local currency, and how that currency moves against yours. Many investors focus on the first and forget the second, yet exchange rates can add to or subtract from your results by a surprising amount. This article explains how currency affects returns, shows it with numbers, and describes ways to manage and monitor it.

Two sources of return

Suppose you live in the United States and buy a share listed in Europe, priced in euros. Your result depends on:

1. The local return: how the share price changes in euros.
2. The currency return: how the euro changes against the dollar.

Your final return is the combination of the two.

A worked example

You invest the equivalent of 10,000 in a European share.

• The share rises 5% in euros, and the euro weakens 5% against your currency. Your investment is now worth 10,000 x 1.05 x 0.95, which is 9,975. You have lost a little, despite a 5% gain in the share.
• The share rises 5%, and the euro strengthens 5%. Now you have 10,000 x 1.05 x 1.05, which is 11,025. The currency added about 5 points to your return.
• The share falls 5% and the euro strengthens 5%: 10,000 x 0.95 x 1.05 is 9,975. The currency softened the loss and then some.

The currency effect is not good or bad in itself. It simply adds a second source of variation to your result.

Why it matters over time

Over short periods, currency moves can dominate. Over very long periods, currencies of similar economies often drift without a clear trend, but large, persistent moves have happened, particularly between countries with different inflation and interest rates. You cannot assume that currency effects will cancel out within your investing horizon.

Currency exposure is not just where the share is listed

A company listed in one country may earn revenue in many currencies. A UK-listed multinational may earn most of its income in dollars, and a US company may sell heavily in Europe and Asia. So a weak or strong currency can affect profits directly, in addition to the effect on your conversion. To understand your true exposure, look at where the company earns and spends, not just where it trades.

Ways to manage currency risk

• Do nothing, deliberately. For a long-term, diversified portfolio, many investors accept currency movements as part of the risk of global investing, on the grounds that they are hard to predict and that costs of hedging can be significant.
• Hold funds with currency hedging. Some funds offer hedged share classes that aim to remove the currency effect. They have costs, which depend partly on the difference in interest rates between the currencies, and they do not remove the underlying share-price risk.
• Diversify across currencies. Spreading investments across several currencies can reduce reliance on any one.
• Match currency to goals. If you will spend in a certain currency, such as your retirement spending, it can make sense to hold a meaningful share of assets in that currency.

Costs of currency conversion

Converting money is not free. Brokers and banks charge fees or add a spread to the exchange rate. Small percentages add up if you convert often. Compare the rates and fees, consider holding a foreign-currency balance if your broker allows, and avoid unnecessary conversions. Dividends paid in a foreign currency are also converted, sometimes at a poor rate.

Reading your portfolio in a base currency

Choose one base currency, normally the one in which your liabilities and spending are, and view your whole portfolio in it. This makes holdings comparable and shows your true result. Many portfolio tools, including this one, let you display values in a chosen currency. Note which holdings are exposed to which currencies, and how much of the portfolio each represents.

Home bias and currency

Many investors hold mostly domestic assets, which keeps currency risk low but concentrates exposure in one economy. Adding foreign assets improves diversification, but brings currency risk. The right balance depends on your goals, your tolerance for variation and your costs.

Common mistakes

• Ignoring currency when judging a foreign investment's performance.
• Assuming currency risk always disappears over time.
• Hedging without understanding the cost.
• Converting money repeatedly at poor rates.
• Forgetting that a company's currency exposure may differ from its listing.

A short checklist

• I know the currency of each holding.
• I view my portfolio in a single base currency.
• I understand what part of the return comes from currency.
• I have compared the cost of converting money.
• I have decided deliberately whether to hedge.

Currency movement is not good or bad in itself, but it is part of the risk and return of global investing, so it is worth seeing clearly.