One of the markets that few investors understand well is the global currency exchange. Most currencies are free floating, which means their relative value can adjust at any time based on the forces of supply and demand. So, when the markets deem the prospects for global growth to be weak while observing that the U.S. economy is relatively strong, as was the case last year, the demand for dollars increases, which in turn raises the value of the dollar relative to most other currencies.
This currency affect can run counter to the forces that move stock returns. Case in point: markets in continental Europe gained 5.2% last year in their local currency (i.e., the Euro) but when those returns were converted to dollars, as they are for U.S. investors, the currency effect reduced the return to a negative 5.7%. That is almost an 11% swing due to the currency adjustment. Similarly, prices on stocks in the Pacific region rose 8.2% last year but the dollar’s climb reduced the return to a negative 2.5%. By year-end currency fluctuations resulted in a net drag on most foreign stock returns and in portfolios with international stock positions.
It is worth noting that currency rates are notoriously volatile and can change direction quickly. Therefore timing the currency market is extremely difficult. The good news is that because the relationship between any one currency and another, e.g., the dollar and the Euro, is dynamic and less than perfectly correlated, the effects of currency movements provide another form of diversification to a portfolio that includes both U.S. and international stocks. Timing asset transfers in the currency markets is not necessary to obtain the benefits of this diversification.