Should You Use Currencies to Diversify?

Posted on December 9, 2011 at 12:04 PM PDT by

Whether it’s the ancient Greeks quipping about moderation in all things or a mom telling her kids to eat their vegetables and not just Otter Pops, diversification in life is broadly understood to be a wise principle. It’s especially true when it comes to investing. Asset allocation is often cited as principle number one, accounting for 90 percent of portfolio returns.

While traders fret and squabble over the next best stock to buy or sell, smart portfolio managers focus on the big picture, spreading money across broad asset classes including U.S. stocks, foreign developed stocks, emerging market stocks, real estate, bonds, inflation-protected securities and sometimes commodities. Asset allocation is supposed to reduce risk within a portfolio by spreading bets across investments that move independently of one another. While one part of your portfolio zigs, the other zags, helping you make money (and preserve capital) in all environments.

Recent critics of asset allocation, however, have pointed out that due to factors such as globalization, many assets including stocks now move in lock step. This trend, they say, is illustrated in the 2008 crash when all sorts of assets fell in tandem, supposedly revealing that the benefits of diversification are ephemeral.

A quick look at the core stock classes in 2008 shows that pain was evenly spread across every major category with U.S. stocks down 36.2 percent, foreign developed down 43.4 percent, emerging market stocks 52.9 percent, and even the nontraditional classes of REITS and commodities hit with declines of 37.6 percent and 31.9 percent respectively. Where is the non-correlation in this asset allocation? These facts, the critics point out, prove that the asset allocation models of the past are now bunk and in need of a desperate overhaul. 2008 is said to have sounded the death knell for all of modern finance. In response, one idea that has gained traction among some managers is the notion of adding global currency as a new type of uncorrelated asset class.

Is Asset Allocation Dead?

Did Modern Portfolio Theory (asset allocation) really die in 2008? MPT does not guarantee that an investor will make money every year. It really does not even say that asset classes will always be uncorrelated. What it does say is that on average, over time, asset classes perform differently, and a diversified portfolio will exhibit less variation in returns than a portfolio with one asset class. This diversification should lower risk, help investors stay the course and achieve their goals over the long haul. Did this hold true?

A look at some diversified portfolios shows that it did. In 2008, bonds returned 5.2 percent. Disciplined investors who kept a strong allocation to bonds experienced much less pain during this historic downturn. A 50/50 split between bond and equity allocation would have reduced losses by more than half. Less pain means a lower likelihood that an investor will panic and abandon their planned course during turbulent times. But woe to those who did bail out. In the following year, U.S. stocks were up 25.2 percent, foreign stocks rallied 31.8 percent and emerging markets gained a whopping 82.6 percent.

More diversified portfolios declined less than the markets over 2008 giving diversified investors the courage to stay with their plan. Those who stayed the course reaped a robust reward the following year.

For a dead idea, MPT worked pretty well.

Should You Add Currencies into Your Mix?

Some MPT advocates suggest that currencies as the new answer for a truly diversified portfolio.

Take currency returns over the past year. While Mexican peso was is down 7.8 percent against the U.S. dollar, the Japanese yen was up 7.5 percent and the Swiss franc up 6.7 percent for the same period. A quick study of currencies demonstrates that they are in fact highly uncorrelated to stocks. Should we then conclude that they belong in your retirement portfolio?

For the average investor, the answer is no for two simple reasons:

  1. A diversified portfolio of stocks and bonds already provides exposure to global currencies. Large U.S. multi-national corporations may trade in U.S. dollars, but they conduct business in foreign lands using foreign currencies. By default they are already affected by currency exchange rates. Furthermore, beware of holding investments that trade in currencies other than the dollar as you are exposing yourself to both the risk of the underlying companies as well as the foreign currency. That presents a lot of risk to understand, let alone manage.
  2. Currency values are tied more to inflation speculation than economic growth. History demonstrates that economic growth does not necessarily result in a stronger currency. If you think corporate profits are hard to predict, try predicting inflation. It’s a daunting task best left to the pros.

Placing all your eggs in one basket remains as bad an idea today as it did forty years ago when the fathers of MPT first began suggesting diversification strategies. Although 2008 was a rough spot for all investors, those who stayed true to diversification through the tumult are smiling today.