A strengthening dollar is tempting many to abandon overseas investments. That can wreak havoc with ensuring their portfolios are well-diversified. Because this too shall pass: Currencies move up or down in any year.
Investing statistics show how thoroughly U.S. investors are cooling on overseas stocks. According to the Investment Company Institute, investment inflows to overseas equity mutual funds in this year’s first three months slowed to a trickle: Just under $4 billion, which is only 8.5% of the first quarter 2013 inflow and 11.5% of 2014’s comparable period. The current trend is very shortsighted.
Last year, the U.S. dollar gained more than 10% against other major currencies around the world (such as the euro and the yen). Was that a good thing?
Well, if you spent significant time traveling in Europe or Japan, you might find it great as hotels and restaurants became more affordable. But what about your investment portfolio? Was a stronger dollar good for your investments?
The answer depends on your asset allocation. Let’s look at what happened last year. The MSCI EAFE Index for developed international markets like Europe, Japan and Australia was down about 4.9% for U.S. investors. But for foreign investors in their own country, the index was up 5.7%. Why? The stronger dollar in the second half of 2014 created a negative currency return for U.S. investors. As the dollar rises, your international investments go down in value.
The Standard & Poor’s 500 index was up 13.5% in 2014. If you were only invested in U.S. stocks, you had a pretty good year. If you just made investment decisions based on last year, then you might be tempted to abandon the concept of global diversification. But this would be a big mistake.
Take a look at this chart from investment advisory firm Callan Associates that recorded the annual returns of some key indexes. In the 20 years from 1994 to 2013, the MSCI EAFE index did better than S&P 500 half of the time. From 2005 to 2007, the international index outperformed the U.S. index by 8.63, 10.55 and 5.68 percentage points. Much of that advantage was due to a weaker dollar.
You may have also noticed the MSCI index for emerging market equities was at the very top of the charts from 2003 to 2007. While these stocks certainly did well during those five years, currency further boosted those positive returns for U.S. investors.
Are we in the phase of a cycle where the dollar will strengthen for years to come? The honest answer is nobody knows. (If you see people on television claim they know, turn the channel.) The best hedge to this uncertainty is to invest small portions of your portfolio in various asset classes globally.
Many investors are over-weighted in U.S. stocks. People tend to invest in things that are familiar. But the U.S. stock market only represents 50% of the global market. A rational investor should want to participate in the gains the whole capital markets have to offer.
One thing we need to remember is that there are years when our international investments disappoint, but there are also years when they provide outsized returns compared with our U.S. investments.
If the dollar strengthens, our international investments relatively decline in value. But when the dollar weakens, our international investments become more valuable. Since no one knows whether the dollar will strengthen or weaken in any year, the best strategy is to stay globally diversified.
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Ken Weingarten, CFP, is the president of financial planning services at Weingarten Associates in Lawrenceville, N.J.
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