Saturday, June 26, 2010

Investors Should Not Worry about EURO

With today's post, I want to take off my currency trader hat and put on my investor hat.

You might be tempted to argue: But wait, these two aren't mutually exclusive. Isn't it possible to wear both hats? While itâ's theoretically plausible for a trader to take a long-term view of the markets based on fundamental analysis, I don't think it's likely in practice. In the end, a good investor will always have a longer time horizon than a good currency trader. In short, someone who bought shares in Apple 20 years ago is now probably a millionaire. Someone who went long the USD 20 years ago has probably since lost his investment due to inflation.

But seriously, currency traders must adapt to the zero-sum nature of forex markets by shortening their time horizon. Stock market investors, on the other hand, are not bound by this constraint. In fact, by holding stocks for a long enough time period, investors can actually turn this into an advantage.

As a result of the Eurozone sovereign debt crisis, for example, some analysts are calling for foreign (i.e. not using Euros) investors to dump their European. investments. This recommendation is not necessarily a dismissal of European companies (though an argument could be made on this basis as well), but rather is a reflection of concerns that returns will be negatively impacted by the declining Euro. Since foreigners can only purchase shares using their home currencies indirectly (through ADRs and ETFs), they feel the effects of currency fluctuations every time they enter and exit a position. Those that entered into a position prior to the Euro’s decline, by extension, will naturally be hurt if they try to exit before the Euro has had a chance to recover.

But therein lies the problem with this approach. Those that dump their shares now solely over exchange rate concerns are simply locking in their losses, just like American stock market investors who sold their stocks in March 2009 when the DJIA was below 7,000. By instead waiting a year (or longer!) such investors could have at least partially neutralized the impact of these crises. Of course, if recovery in the Euro was perceived as inevitable, then portfolio investors naturally wouldn’t think about divesting from EU capital markets. The concern is that the Euro will continue to decline, perhaps to the point of breakup.

I don’t want to dig myself into a hole by making a 5-year prediction for the Euro, especially since there is a part of me that is concerned that it will continue to decline. Based on history, however, there is very little reason to believe that will be the case. I’m not talking about economic fundamentals â€" about how the US fiscal position is equally precarious and how currency markets might recognize this and turn on the Dollar â€" but rather about the nature of forex markets.

Euro Dollar 5 Year Chart 2005-2010

Simply, currencies fluctuate. Since its introduction 10 years ago, the Euro has fallen, then risen, then fallen, then risen, then fallen again to its current level. If you initially invested in Europe 2 years ago, the exchange rate would erode your returns if you tried to sell now. If you invested 5 years ago, you would break even. If you invested 10 years ago, you would come out ahead. In the end, it’s only a question of perspective. Still, if you maintain your positions for long enough, either you will break-even from the exchange rate or it will only marginally affect your returns (on an annualized basis).

Consider also that you can hedge your exposure to a falling Euro by simply buying Dollars. If you are concerned about exchange rate risk, you can do this every time you open a position. For example, if you were to buy European shares today and simultaneously short an equal quantity of Euros, you would be perfectly hedged against any further decline in the Euro. The cost of the hedge is the sum of any transaction costs, management fees, and negative carry that you incur as part of the currency trade.

In short, unless you deliberately want to speculate on exchange rates, don’t worry about them! If your investing horizon is long enough, their fluctuations will neither help nor hurt you in a meaningful way.

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