How to Invest in a World with Fluctuating Exchange Rates
Cartoon characters have neat tricks that help them avoid disaster. When one of our heroes is trapped in a falling house, the solution is simple. Just as the house is about to crash into the ground, Bugs, Daffy, the Road Runner, and others simply step out of the house. They walk away from the wreck with nary a scratch.
While we cannot exit falling houses without injury, we can leave behind declining currencies. For the last few years, my wife and I have owned a good-sized position in bonds issued by the German Central Bank. The bonds pay low interest rates of no more than 4.5% annually. In spite of the low interest rates we have been earning more than 10% a year on our German bonds.
The payoff from owning euro bonds is the interest rate plus the change in the currency. For example, we bought some of these German bonds in 2001. At the time each U.S. dollar bought 1.1 euros. For each $1,000 that we invested we received more than 1,100 euros' worth of bonds. When those bonds matured a year later, the 1,100 euros had grown to 1,133 euros (3% interest rate). Furthermore the dollar had declined in value so the dollar value was almost $1,150. So in one year these euro bonds earned 3% interest plus more than 10% in currency change for a 15% return.
To avoid being hurt by a falling U.S. currency, the goal is to escape the falling house. The protection is to own investments in nondollar currencies. A simple and effective solution is to buy non-U.S. stocks and non- U.S. bonds.
There are two subtleties to this guidance. First, a company's exposure to the dollar is not determined by the location of its corporate headquarters. For example, Toyota may have more exposure to the U.S. dollar than does Microsoft. Toyota sells a lot of cars in the United States , and Microsoft sells lots of software outside the United States . So the definition of a non-U.S. stock depends on the location of sales.
Second, a declining dollar puts pressure on foreign companies. For example, the weakening dollar has made German goods less attractive and consequently fewer German workers have jobs. Remember that the U.S. current account shrinks when Americans stop buying Italian handbags and German cars. That means the companies who make Italian handbags and German cars need fewer workers. The savvy investor has to escape the effects of the falling dollar both within the United States and in other countries.
How much should be invested in nondollar assets? My advice for the average investor is 15% of net worth. To minimize risk of currency fluctuations, I suggest that people align their investments with their buying behavior. For example, the average American spends about 15% of her or his income on foreign goods. Thus, a completely reasonable, and low- risk strategy suggests that 15% of an investor's net worth be invested in nondollar assets. Those who want to speculate with me on a further dollar decline, and those with a taste for foreign goods, could allocate even more to foreign investments.