A lot of people these days use investment platforms to build their wealth. And that’s a good thing. We always want to expand the capital-owning class. It makes for a much more stable world.
But these platforms offer a heck of a lot of choices. You can buy pretty much any instrument you want in the world with the push of a button. And that means that you’re sometimes buying assets that are not denominated in your home currency. Is that a problem?
Imagine you live in the UK but want to buy an ETF based in the US. When you hop onto one of these platforms to do so, the price you must pay embodies the exchange rate on the forex market. If the pound is strong, you can buy more dollars to buy the ETF. If the pound is weak, you can buy less.
At this stage, a lot of people start to get very nervous. What happens if you invest at a time when the pound is weak and then strengthens over time?
Well, unfortunately, the value of your investment in terms of pounds will fall. When you sell your dollar-denominated ETF, the dollars you gain can buy fewer pounds, making you worse off.
However, at the same time, the opposite can happen. Let’s say that you buy when the pound is strong and then it weakens over time. Over time, the dollars embodied in your US ETF become more valuable in terms of Sterling, allowing you to buy more of it.
It looks like a classic case of swings and roundabouts when you view it in this way. Sometimes changing exchange rates increase your wealth, and sometimes they make it fall. But does the effective eventually wash out, leaving no change?
Well, it all depends on the length of your investing horizon. If you want to invest for a few months and then take your money out of the market to cash in, then currency risk is a problem. Currencies tend to fluctuate considerably in a band over the space of two to five years. So if you invest short term, the value of your investments might go down in terms of pounds, even if they went up in dollars.
Over the long-term, however, it is a different story. The relative value of the world’s major currencies barely changes over time. Yes – there have been macro trends. But in general, currencies all tend to fall at the same rate because central banks are getting good at holding inflation close to the 1 to 2 per cent level.
That might change in the future, of course. But if you do invest in international ETFs, the best outcome is to buy when the currency is strong and then sell many years later when it is temporarily weak. That way, you can extract maximum purchasing power from your assets when you come to spend them.
The bottom line is this: if you’re investing short-term, you need to take currency risk into account. If you’re in it for the long-term, then it doesn’t matter so much.