Bogle worried about currency risk in Int'l Stocks

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neomutiny06
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Bogle worried about currency risk in Int'l Stocks

Post by neomutiny06 » Fri Dec 30, 2016 11:18 am

I am reading "Common Sense on Mutual Funds" and John Bogle states that he does not like international investing. Many of his reasons seem to relate to a "home country bias" where he favors the US. I don't agree with that point of view. I think nobody can say which countries will do the best in the future.

However, he also discusses currency risk. He says, in the long run, currencies should prove equal. But there may be long periods of a weaker or stronger dollar. And he says swings can make international returns seem much better than they really are.

I don't truly understand currency fluctuations, but I don't see currency discussed on this board all that often. Especially with so many of us investing internationally. For the long-term, is this a concern for any of you like it is for Bogle?

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Re: Bogle worried about currency risk in Int'l Stocks

Post by czeckers » Fri Dec 30, 2016 11:27 am

With the current strength of the dollar, you get more bang for your buck when buying international. Also, international valuations are more favorable. Emerging markets are near their long-term PE10 average. European domestic are significantly below. On the other hand, US valuations have been above long-term averages for a few years now.

I'm not saying give up on US equities nor am I advocating for going all in on international funds. However, now is not a bad time to go with an international allocation if you have been contemplating such a move.

It's also not a bad time to go on a European vacation.

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Re: Bogle worried about currency risk in Int'l Stocks

Post by whodidntante » Fri Dec 30, 2016 11:28 am

It's kind of like bond prices in June. How much stronger can it really get? OK now substitute the dollar for bond prices.

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Re: Bogle worried about currency risk in Int'l Stocks

Post by nisiprius » Fri Dec 30, 2016 11:35 am

Currency risk gets discussed almost any time the subject of international stocks comes up. This posting is sure to trigger the usual spirited debate. I'm going to try very hard to say my piece and then not post further in this thread.

John C. Bogle's position on international stocks is something of a thorn in peoples' sides, by the way, and is probably the most common thing about which people say "I don't agree with Bogle."

To me, personally, currency risk represents a rational reason for "underweighting" international stocks versus the U.S. The normal rationale for cap-weighted indexing implicitly assumes a common currency. My personal view is that this does not carry over to when multiple currencies are involved; currency risk adds unrewarded risk whenever an investor invests in securities denominated in a different currency from his home currency.

In particular, for a U.S. investor I expect the Sharpe ratio for international stock funds to be lower than for U.S. stock funds--and it has been. So that's effectively a drag on the quality of the whole portfolio. However, international stocks have an imperfect correlation with U.S. stocks, so they add diversification, and that is a boost to the whole portfolio. So it is a balancing act, and my own poking around seems to show that the diversification benefit does not outweigh the currency-risk handicap. Most MPT-based examinations which are based on the past show that in the past, the optimum ratio would have been around 25%-30% international stocks, which is much lower than the cap-weighted allocation of about 50%.

Notice that currency risk is bidirectional. It doesn't reduce return, but it does add extra uncertainty. There's no reason for the market to reward this uncertainty because it is unnecessary risk--when you buy international stocks you are competing with home-currency investors who do not have this risk.

I have to say that to some extent I am pushing back on what I perceived to be a hard sell on international stocks that seemed to begin perhaps fifteen or twenty years ago. I am skeptical. The arguments for international stock investing exist, but the advantages are surprisingly small and elusive, and the intensity of the push for international stocks is all out of proportion to the seeming merits. It is enough to harden my sales resistance. This is underlined by the largely unexplained big changes in mainstream recommendations over time. People have been investing in international stocks for centuries, and foreign-stock mutual funds with expense ratios in the same ballpark as U.S. stocks have existed at least since the 1970s, but up to about 1990 they were not normally recommended as a basic portfolio choice. Burton Malkiel's own recommendations have increased from about 1/6th-of-all-stocks in 1990 to 1/2-of-all-stocks today. I personally think this is nothing more than trendiness--there's no objective reason why international stocks would be a nice-to-have-maybe-a-little in 1990 but a must-have now.
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Re: Bogle worried about currency risk in Int'l Stocks

Post by danaht » Fri Dec 30, 2016 11:45 am

I think currency "risk" is a great reason to hold international stock. If everything you own is in US dollars - you are taking one big risk with the US currency. Granted the US currency is currently considered the world's best currency - it may not be in 20 years. Essentially - international investment allows one to buy into multiple currencies - thus reducing any type of "single" currency risk. This is essentially the same principle as owning an index fund - you buy an index fund so you don't have a risk in owning only one stock.

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Re: Bogle worried about currency risk in Int'l Stocks

Post by neomutiny06 » Fri Dec 30, 2016 11:54 am

danaht wrote:I think currency "risk" is a great reason to hold international stock. If everything you own is in US dollars - you are taking one big risk with the US currency. Granted the US currency is currently considered the world's best currency - it may not be in 20 years. Essentially - international investment allows one to buy into multiple currencies - thus reducing any type of "single" currency risk. This is essentially the same principle as owning an index fund - you buy an index fund so you don't have a risk in owning only one stock.


Yes, this makes sense. However, I would reply by saying that we earn and spend our money in Dollars. This is Bogle's point as well. That is what I'm trying to figure out. I understand diversification. But I will always live in America and spend in dollars. If the conversion back to the dollar hurts my returns, perhaps I should lower my international exposure.

And yes, to Nisiprius point, international stocks were never a must have. But now they are big time. I worry about new fads.

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Re: Bogle worried about currency risk in Int'l Stocks

Post by CaliJim » Fri Dec 30, 2016 12:22 pm

There is much to be said for investing in the same currency with which one consumes.

However....

I think the risks associated with investing internationally are offset by the reduction of risk achieved by diversifying one's investments outside the United States. Investing only in the US, or one's home country, results in concentrated political risk.

The future is unknowable and unpredictable. No country or currency lives forever.
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Re: Bogle worried about currency risk in Int'l Stocks

Post by Nate79 » Fri Dec 30, 2016 12:41 pm

Does the US dollar change equally against all the other currencies or is it a currency specific fluctuation? By investing in Total international fund you don't invest in one specific foreign country. Anyways, the revenue of the companies in the S&P500 is made up of something like 30% foreign sales well diversified across the spectrum of currencies. Just because you don't choose to invest in International fund doesn't mean you aren't exposed to the issue of currency fluctuation.

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Re: Bogle worried about currency risk in Int'l Stocks

Post by nedsaid » Fri Dec 30, 2016 12:44 pm

Yes, currency risk is there but that is part of what gives International Stocks a diversification benefit. Over longer periods of time, currency swings pretty much even out.
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Re: Bogle worried about currency risk in Int'l Stocks

Post by Bfwolf » Fri Dec 30, 2016 12:48 pm

Yes, currency risk is real assuming you will be spending the money in US$s. This is a good reason to hold less than the cap weight (around 50%) of equities in International. Many people hold 20% to 40% of their equities in Int'l for this reason.

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Re: Bogle worried about currency risk in Int'l Stocks

Post by neomutiny06 » Fri Dec 30, 2016 6:33 pm

Bfwolf wrote:Yes, currency risk is real assuming you will be spending the money in US$s. This is a good reason to hold less than the cap weight (around 50%) of equities in International. Many people hold 20% to 40% of their equities in Int'l for this reason.


Ok this is interesting. Because of currency risk, many Bogleheads stay below 40% in international. I keep reading about currency risk and most say that over time, it is expected to be a wash. But how do we know that will happen? And by investing in international, and the dollar does poorly over time, is that a double whammy for our portfolios?

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Re: Bogle worried about currency risk in Int'l Stocks

Post by Clive » Fri Dec 30, 2016 7:59 pm

Firms with global/foreign earnings tend to currency hedge to the currency/country they list in, for the greater stability that provides. Sticking with a single stock market/country set of stock listings is a concentration risk, unfavourable taxes/regulations (US applies a 30% dividend withholding tax to foreign investors, UK 0% rates such dividends) could be imposed by the state, or in exceptional circumstances the markets might be closed (2012 Hurricane Sandy for instance).

Like with FX/currency trading if some large scale stock influencing event occurs then its nice to have the 'free' insurance of 'extended trading' hours such that you can dump some holdings ahead of the crowd if the need arises (i.e. in foreign markets that open earlier due to local time zones). Bad news hits the headlines during the weekend, Sydney market opens at 6pm Sunday evening New York time type of thing.

Currencies tend to wash, except if your domestic currency is the one under stress and all others rise relative to that. CISCO listed in Mexico for instance will compare to CISCO US listing after FX conversion. Ditto BHP Billiton listed in Australia and London ... etc.

As a UK investor, during the 2008/9 financial crash, both US and UK stocks dived by around similar amounts however GB£ weakened relative to the US$ that pretty much negated the US stock price declines (MCD actually provided gains (for UK investors) due to remaining somewhat level, but after USD/GBP conversion provided a gain). Currency 'risk' doesn't always work against you and can be a 'reward'.

During the 1970's/80's Japan grabbed a big chunk of the world market cap, mostly reducing the US's share of global market cap (knocking it down from near 75% levels to 25% levels). The US managed to double that up back to 50% type levels during the 1990's as Japan's share dived. If you held a global stock index then those fluctuations mattered less than if concentrated in one or the other alone.

As unlikely it may be for any one country stock market to fail, there are cases of where that has happened. In contrast the likelihood of a total global stock index collapse is as good as impossible (could happen but if it did that would be the least of your worries). More ideally 'International' should include brokerage accounts globally diversified. A single international fund that lists in a single market foregoes some of the benefits/free-insurance. That needn't be too complicated however, for instance TDDirectInvesting (TDWaterhouse/TDAmeritrade ... whatever they're known as locally to you) UK's division includes the option to trade in something like 17 markets, 9 currencies all within the same single account.

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Re: Bogle worried about currency risk in Int'l Stocks

Post by stemikger » Fri Dec 30, 2016 8:17 pm

John Bogle has a nasty habit of being right most of the time. I'll stick with Jack on this one and don't sweat it.
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Re: Bogle worried about currency risk in Int'l Stocks

Post by larryswedroe » Fri Dec 30, 2016 8:54 pm

Few thoughts here

First, one of the most common and biggest mistakes investors make about currency risk is that they think of it as one way street, the foreign currencies will fall in value. Well there is also the risk the dollar will fall in value and for reasons that can be very damaging including economic and political risks. That is why almost all agree the academics agree that one should have international exposure (to diversify those risks) and that one should NOT hedge the currency risk on equities because it serves to increase the correlation to US stocks and thus reduces the diversification benefits. And thus IMO it is NOT a reason to underweight foreign equities. The only reasons IMO to do so are because it costs a bit more and may be a bit less tax efficient (or if you cannot handle the tracking error risk). On other hand if you are working almost certainly your labor capital is highly correlated to US economic risks and that is reason to overweight international.

Second, if a currency falls in value exports become more competitive and imports less so allowing profit margins to widen. And if you ever needed a better example consider the following which I wrote about when just a few years ago when investors were so concerned about the dollar losing it's status as world reserve currency and what that would to its value (and stocks).
I would be no one would guess this outcome. Quoting from my piece

"Prior to the dollar taking that role, the British pound was the world’s reserve currency. It lost that status shortly after World War II. Not only that, but Britain industrial capacity was devastated. So, how have British stocks performed since? We have data on the FTSE All-Share Index going back to February 1955. Given these conditions, you’d think that U.K. stocks would have done poorly relative to U.S. stocks. And you’d be dead wrong. From February 1955 through February 2014, the FTSE All-Shares Index returned 11.0 percent in dollar terms, outperforming the S&P 500 Index, which returned 10.3 percent.

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Re: Bogle worried about currency risk in Int'l Stocks

Post by nisiprius » Fri Dec 30, 2016 9:14 pm

Sorry, need to rework something.
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Re: Bogle worried about currency risk in Int'l Stocks

Post by jalbert » Fri Dec 30, 2016 9:15 pm

Int'l stock holdings diversify USD currency tail risk, but create a mismatch with USD-based liabilities, so they increase the variance of asset-liability mismatch. The latter is more a risk of normal fluctuations, whereas the tail risk of USD exposure is a much less likely high US inflation scenario.

I consider risk diversification and ignore PE measures in deciding on an int'l equity allocation. The reason US PE measures are higher than int'l ones is that US equity returns have smoked int'l equity returns even going back to the start of 2002 when EM took off. If you timed the market and increased int'l allocations when PE's were first mis-aligned, you missed out on a lot of return. Thus, it is preferred to decide on an allocation based on risk management principles, and stick with it.

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Re: Bogle worried about currency risk in Int'l Stocks

Post by letsgobobby » Fri Dec 30, 2016 9:28 pm

neomutiny06 wrote:
danaht wrote:I think currency "risk" is a great reason to hold international stock. If everything you own is in US dollars - you are taking one big risk with the US currency. Granted the US currency is currently considered the world's best currency - it may not be in 20 years. Essentially - international investment allows one to buy into multiple currencies - thus reducing any type of "single" currency risk. This is essentially the same principle as owning an index fund - you buy an index fund so you don't have a risk in owning only one stock.


Yes, this makes sense. However, I would reply by saying that we earn and spend our money in Dollars. This is Bogle's point as well. That is what I'm trying to figure out. I understand diversification. But I will always live in America and spend in dollars. If the conversion back to the dollar hurts my returns, perhaps I should lower my international exposure.

And yes, to Nisiprius point, international stocks were never a must have. But now they are big time. I worry about new fads.

Think about all your assets: your home. your vehicles. your bonds. your cash. your human capital. What percent is already denominated in US dollars?

I have a US bias: including my 60% of stocks that are international, about 65% of all my assets are dollar denominated. Throw in my human capital (which would not easily translate to another country, language, or culture) and I am heavily exposed to the US dollar. 60% international stocks is the least I can (or should) do.

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Re: Bogle worried about currency risk in Int'l Stocks

Post by larryswedroe » Fri Dec 30, 2016 9:28 pm

jalbert
That statement about mismatch might be generally correct, especially for US investors since imports are relatively low percentage of gnp. However, a falling dollar can put upward pressure on prices as US competitors face less competition from more expensive imports while also raising the costs of imports, and likely commodities in general. So it's not completely one sided.
Larry

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Re: Bogle worried about currency risk in Int'l Stocks

Post by nisiprius » Fri Dec 30, 2016 9:39 pm

1) The phrase "currency risk" means something. It does not mean "the risk that my home country's currency will collapse." It means "the extra risk that one takes whenever one performs a transaction in a foreign currency; the extra uncertainty in price cause by fluctuations in the rate of exchange." When someone who normally earns and spends dollars buys dollar-denominated U.S. stocks, there is no currency risk. No transborder transaction, no currency risk.

2) If one's home currency collapses, there will be all sorts of financial chaos. I am skeptical about the usefulness of a international stock allocation in this situation, for two reasons: first, I don't think many of us really have all that large a fraction of our personal wealth in international stock; second, in a true currency collapse, nations often impose all kinds of currency controls and restrictions. There may be limits, or you may be forced to exchange foreign currencies at an "official" exchange rate which is ten times lower than the foreign currency is really worth, etc.

3) It is frequently debated and I could be wrong, but just I do not see how currency fluctuation can possibly add valuable or helpful diversification. Not unless you add some really strong and weird assumptions, about its behavior, such as that the U.S. dollar never does anything but weaken (and thus foreign currency has a positive long-term rate of return), or that foreign currencies actually have a strong negative correlation--not zero, but negative--with U.S. stock prices. If you assume that the long-term return is zero, and you also assume that the correlation with the rest of the portfolio is low or even zero but not negative, it won't help.

We can explore this by asking the question: consider a portfolio of 60% Total Stock and 40% cash (dollars). Will we improve it by replacing the 40% cash with 40% in foreign currency, as represented by the MERKX Hard Currency Fund? If we buy the "diversification always helps" argument, it seems as if maybe it should.

After all, over the full time period for which PortfolioVisualizer has data--essentially the life of the MERKX fund--it actually had a CAGR of 1.54%, not the zero we might expect from foreign currencies in the long run, and higher than the 1.04% for PortfolioVisualizer's "CASHX" asset. And its correlation with Total Stock was only 0.34. So, we're replacing CASHX with something that has similar, slightly higher return, and low correlation with stocks. Shouldn't it help?

PortfolioVisualizer backtest

Portfolio 1: 60% Total Stock, 40% CASHX
Portfolio 2: 60% Total Stock, 40% Merk Hard Currency Fund.

Image

And the result was: replacing CASHX with foreign currency reduced the Sharpe ratio from 0.53 to 0.45, even though currency fluctuation was a two-way street and actually came out ahead over this time period. Why? Because MERKX only increased CAGR by a small amount, 5.53% to 5.65%, but it increased standard deviation, volatility, "risk," by a large amount, 11.65%. The intrinsic volatility of MERKX itself outweighed the small degree to which its uncorrelated fluctuations smoothed or filled in the fluctuations of Total Stock.

So the last question we need to ask is: does a Swedish krona behave differently when it is a holding within MERKX than it behaves when it is entangled in the price of a Swedish stock? I don't think so. If currency fluctuations don't improve a portfolio when we replaced a cash fund with a foreign currency fund, then I don't see how why they would improve a portfolio when we replace stocks priced in dollars with stocks whose price involves a krona-dollar exchange.
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Re: Bogle worried about currency risk in Int'l Stocks

Post by letsgobobby » Fri Dec 30, 2016 10:27 pm

Nisi, you may be overthinking this. The reason I own international stocks is that the US dollar could weaken substantially just when I can least afford it. That's how I interpret currency risk. Therefore I have to diversify. It is akin to the reason I own bonds. Stocks return more over almost any long period of time. But if they fail to do so just when I am ready to retire, averages don't help me at all.

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Re: Bogle worried about currency risk in Int'l Stocks

Post by Wakefield1 » Fri Dec 30, 2016 10:35 pm

stemikger wrote:John Bogle has a nasty habit of being right most of the time. I'll stick with Jack on this one and don't sweat it.

:sharebeer :idea: :idea: :idea: :idea: :idea: :idea: :sharebeer

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Re: Bogle worried about currency risk in Int'l Stocks

Post by Punta Cana DR » Fri Dec 30, 2016 10:40 pm

Wow...board is getting Buffett?

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Re: Bogle worried about currency risk in Int'l Stocks

Post by arcticpineapplecorp. » Fri Dec 30, 2016 10:47 pm

neomutiny06 wrote:
danaht wrote:I think currency "risk" is a great reason to hold international stock. If everything you own is in US dollars - you are taking one big risk with the US currency. Granted the US currency is currently considered the world's best currency - it may not be in 20 years. Essentially - international investment allows one to buy into multiple currencies - thus reducing any type of "single" currency risk. This is essentially the same principle as owning an index fund - you buy an index fund so you don't have a risk in owning only one stock.


Yes, this makes sense. However, I would reply by saying that we earn and spend our money in Dollars. This is Bogle's point as well. That is what I'm trying to figure out. I understand diversification. But I will always live in America and spend in dollars. If the conversion back to the dollar hurts my returns, perhaps I should lower my international exposure.

And yes, to Nisiprius point, international stocks were never a must have. But now they are big time. I worry about new fads.

Read the following (there's a similar thread here):
viewtopic.php?f=10&t=206800

This is what I wrote in that post and it applies equally as well here:
by arcticpineapplecorp. » Fri Dec 30, 2016 5:13 pm

It depends on how well (or poorly) the individual countries do doesn't it, and the percentage those countries represent in your total international stock market index fund (and then what percentage that fund represents of your entire portfolio) and whether the currency when converted from local back to U.S. is beneficial or not.

You might want to check out the following website:
http://www.yardeni.com/pub/peacockglstkytd.pdf

This site shows how well different countries did individually (and as a group) in local currencies and in U.S. dollars. You can see that some countries could be up in local currency but down when converted to U.S. dollars. Take for instance, the U.K. which is UP 14.2% in their local currency (that's better than how the S&P500 did). However, in U.S. dollars that translates to a 4.2% LOSS. Similarly Europe as a whole in local currency (Euro) is UP 3.8% but when converted into U.S. dollars translates to 4.2% LOSS.

Remember currency flucutations cut both ways (sometimes hurt, other times help). Latin America was up in local currency 21.5% but when converted to U.S. dollars was up 28.3% (thanks strong U.S. dollar). Brazil was up 32.7% in local currency but when converted to U.S. dollars was up 61.8%. Russia was up 27.9% in local currency but converted to U.S. dollar is up 48.5%. South Africa was up 2.0% in local currency but 15.8% when converted to U.S. dollars. See how some countries you might have never guessed are actually helping your portfolio?

In other words, it could be said that some international countries have had great gains (Russia, Canada, Latin America, Taiwain, Pakistan). Unfortunately these countries might represent a small part of your international portfolio. And other countries Euro, U.K., etc. might have done ok but due to the drop in value of the Euro and Pound Sterling relative to the U.S. dollar, actually didn't help returns (and actually hurt returns). And those U.K., Europe and Japan are the biggest parts of the total international stock market index fund.

So investing internationally means taking currency risk. I think we (in the U.S.) seem to get spooked by this more than others because others are used to dealing in different currencies more than we are. Got to get over it if you're going to invest worldwide. Hope that helps.
"Invest we must." -- Jack Bogle | “The purpose of investing is not to simply optimise returns and make yourself rich. The purpose is not to die poor.” -- William Bernstein

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Re: Bogle worried about currency risk in Int'l Stocks

Post by nisiprius » Fri Dec 30, 2016 10:50 pm

letsgobobby wrote:Nisi, you may be overthinking this. The reason I own international stocks is that the US dollar could weaken substantially just when I can least afford it. That's how I interpret currency risk. Therefore I have to diversify. It is akin to the reason I own bonds. Stocks return more over almost any long period of time. But if they fail to do so just when I am ready to retire, averages don't help me at all.
The dollar index lost about half its value over three-year period 1985-1988. Was that period of time a personal financial crisis for you, or for the country? It wasn't for me; I remember it as being pretty good. Inflation over that period averaged 3.1%/year. The stock market averaged 18.1% nominal, or over 14%/year inflation-adjusted.

If you don't remember that time period, how about 2002-2007, during which the dollar weakened by over 30%. During 2002-2007, did your personal finances weaken by 30%? Of course, the stock market crashed in 2008-2009, but I haven't heard it suggested that the dollar weakening caused it. Nor did international stocks cushion the blow.

Obviously, if you live outside the United States and depend on income from dollar-denominated investments in the U.S. that's not a good situation, and there's a serious personal risk if the dollar weakens.

A "weakening dollar" sounds bad, but is it?
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Re: Bogle worried about currency risk in Int'l Stocks

Post by letsgobobby » Fri Dec 30, 2016 11:17 pm

nisiprius wrote:
letsgobobby wrote:Nisi, you may be overthinking this. The reason I own international stocks is that the US dollar could weaken substantially just when I can least afford it. That's how I interpret currency risk. Therefore I have to diversify. It is akin to the reason I own bonds. Stocks return more over almost any long period of time. But if they fail to do so just when I am ready to retire, averages don't help me at all.
The dollar index lost about half its value over three-year period 1985-1988. Was that period of time a personal financial crisis for you, or for the country? It wasn't for me; I remember it as being pretty good. Inflation over that period averaged 3.1%/year. The stock market averaged 18.1% nominal, or over 14%/year inflation-adjusted.

If you don't remember that time period, how about 2002-2007, during which the dollar weakened by over 30%. During 2002-2007, did your personal finances weaken by 30%? Of course, the stock market crashed in 2008-2009, but I haven't heard it suggested that the dollar weakening caused it. Nor did international stocks cushion the blow.

Obviously, if you live outside the United States and depend on income from dollar-denominated investments in the U.S. that's not a good situation, and there's a serious personal risk if the dollar weakens.

A "weakening dollar" sounds bad, but is it?


There have been plenty of cases throughout the world in which the loss of 30% of your home country currency would have been devastating. And there have been plenty of cases in which your currency lost 50%, or 90%, or 100%. Just because it has not happened in the US, yet, does not mean it cannot happen.

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Re: Bogle worried about currency risk in Int'l Stocks

Post by abuss368 » Fri Dec 30, 2016 11:28 pm

My understanding is currency risks washes out with stocks over periods on time. For bonds however, it is generally preferred to hedge that risk.
John C. Bogle: "You simply do not need to put your money into 8 different mutual funds!" | | Disclosure: Three Fund Portfolio + U.S. & International REITs

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Re: Bogle worried about currency risk in Int'l Stocks

Post by abuss368 » Fri Dec 30, 2016 11:29 pm

Jack Bogle has often recommended a simple balanced fund or the Two Fund Portfolio which is Total Stock and Total Bond.

We should start a thread to see who follows that approach.
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Re: Bogle worried about currency risk in Int'l Stocks

Post by Watty » Sat Dec 31, 2016 12:47 am

Figuring out currency risk for stocks get even more complex when you consider that roughly half of the S&P 500 earnings come from international sales.

Likewise many marge international companies have a lot of sales in the US market.

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Re: Bogle worried about currency risk in Int'l Stocks

Post by jalbert » Sat Dec 31, 2016 1:09 am

larryswedroe wrote:That statement about mismatch might be generally correct, especially for US investors since imports are relatively low percentage of gnp. However, a falling dollar can put upward pressure on prices as US competitors face less competition from more expensive imports while also raising the costs of imports, and likely commodities in general. So it's not completely one sided.
Larry

As long as the dollar doesn't collapse or inflation explode as in the 1970's, a weak dollar provides pricing power to US companies as you note. It also is likely to reduce corporate debt in real terms. These are likely to be very positive for US equities. Non-US goods will be pricier, which may or may not hurt non-US companies, but their strong currencies should deliver robust returns for non-US equities to US investors. The US investor should do fine at 100% US equities or with a high int'l allocation in this scenario.

Protecting against high inflation in the US, essentially currency downside tail risk, is the reason I allocate equities to non-US stocks at about 25% of equities.

In the strong dollar scenario, non-US companies become more competitive, non-US goods become inexpensive for US investors, but the US investor has difficulty realizing the benefit in USD-terms due to the strong dollar. A US investor should do fine at 100% US equities in this scenario as well.

Although US equity returns have been generous during the current strong dollar scenario, a strong dollar could also be associated with a deflation scenario, and, while US equity returns likely would suffer, non-US equities could get totally crushed in USD terms. This is the mirror image of the high inflation scenario, essentially USD upside tail risk for US investors, and why I limit non-USD equities at about 25% of equities.

I try to find the midpoint between hedging inflationary currency tail risk and deflationary currency tail risk. I don't know what that is (probably nobody does), but because my liabilities are generally in USD, I have decided on 76% US and 24% DM as my best guess at the tradeoff between managing these two risks (partly motivated by the results of a couple of studies I have read that may nonetheless be incorrect). I stuck with this allocation through the EM/commodities bubble of 2002-2007, stuck with it through the current strong dollar cycle, and have found it to be resilient for my needs.

Of course, the risks I described should be managed by overall portfolio allocation, not just equity allocation, and a young retirement saver with a very long time horizon may be less sensitive to the currency of retirement liabilities.

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Re: Bogle worried about currency risk in Int'l Stocks

Post by stemikger » Sat Dec 31, 2016 2:34 am

abuss368 wrote:Jack Bogle has often recommended a simple balanced fund or the Two Fund Portfolio which is Total Stock and Total Bond.

We should start a thread to see who follows that approach.


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Re: Bogle worried about currency risk in Int'l Stocks

Post by Caduceus » Sat Dec 31, 2016 5:07 am

For stocks and ETFs that trade in baskets of stocks, I don't see why there is much in the way of currency risk. Financial institutions can easily trade across borders, so there are few limits to arbitrage. When the Euro and GBP depreciated against the USD, Vanguard's European-domiciled ETFs surged (in their local currency terms), so when you convert it back to USD-denominated terms, it all evened out.

For instance, Vanguard has a European fund denominated in USD (VGK) and the same fund denominated in a mixture of GBP and Euro (VEUR). When the Euro and GBP declined against the USD earlier in the year, the European version enjoyed strong currency - as opposed to fundamental - returns. You can overlay the charts of the two funds with changes in exchange rates. This is why I don't quite understand why people are so worried about a weaker currency. The fund with the weakening currency in a currency pair will simply result in a stronger currency-related return, otherwise the differences will get arbitraged away.

My guess is that currency risk matters more for assets that can't easily be traded by many market participants. For things like stocks, there's no reason why currency movements should not be immediately priced accordingly across the different markets.

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Re: Bogle worried about currency risk in Int'l Stocks

Post by Clive » Sat Dec 31, 2016 6:45 am

Bonds (10+ years), Notes (2 to 10 years), Bills (up to 1 year) ... Currency (immediately swappable 0% yield) tend to be more commonly collectively classified as 'Bonds'. Should you hold bonds issued solely by a single entity, or diversify across different providers as sooner or later a idiot may be in control.

States can partially (or even fully) default on their 'bonds'. Most will avoid outright defaults and instead use more opaque methods, such as printing more or adjusting taxation. Printing is like counterfeiting, the person who prints gets to spend that money at the expense of devaluing all other notes in circulation, a form of taxation when performed legally.

Holding a bunch of stocks issued by a single entity denominated in a single currency is concentration risk. More so when many of the individual stocks (as they typically tend to do) also hedge their foreign business activities/earnings back into the same currency.

Whilst one State may be better at managing things and less likely to have a idiot in control, concentration can lead to a single large loss. Others may be more likely to have a idiot in control but when so diversification avoided a critical loss. A more frequent occurrence of a smaller proportion loss is generally better than a less frequent occurrence of a total loss. Concentration risk is made worse by the fact that it doesn't have to be the result of a idiot in control, but can also be a consequence of Black Swan outcomes. Sudden unexpected high financial cost events arising out of accident or misfortune.

A choice between geopolitical diversification or concentration.

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Re: Bogle worried about currency risk in Int'l Stocks

Post by abuss368 » Sat Dec 31, 2016 1:49 pm

stemikger wrote:
abuss368 wrote:Jack Bogle has often recommended a simple balanced fund or the Two Fund Portfolio which is Total Stock and Total Bond.

We should start a thread to see who follows that approach.


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Re: Bogle worried about currency risk in Int'l Stocks

Post by inbox788 » Sun Jan 01, 2017 6:24 pm

I thought currency risk was part and parcel the reason to invest in International Funds. The part that always confused me is whether you want to buy them in dollar denominated vs Euro/Yen/etc, but for the multinational funds (i.e. VXUS, etc.), I assume they're all dollar denominated.

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Re: Bogle worried about currency risk in Int'l Stocks

Post by larryswedroe » Sun Jan 01, 2017 7:11 pm

inbox
Yes currency risk is one of the reasons you want to own international stocks, it diversifies the economic and political risks of the US.
Pretty simple and common sense.

The funds of the vast majority of international funds are NOT hedged against currency risk. That might also be a clue as to what is the right way to think about things. Clearly only a very small minority think one should not want to have the currency risk or more funds would be hedged against that risk. Remember that while most investors think of it as one way street, it's actually two way.

Larry

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