Learn how to reduce the impact of currency risk on your international investment returns

While international investing provides good opportunities for investors, it also comes with some risks. Currency fluctuation is one of them. Read how currency hedging (trading in foreign currencies for U.S. dollars) can help reduce the impact of currency risk on your international investment returns.

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Akweli Parker: This one is from Nagaraj in Voorhees, New Jersey, who asks us to “Please explain currency hedging.”

Kim Stockton: Sure. So, currency hedging is done with a forward contract. It’s when two parties agree to exchange one currency for another at a set rate in the future. And the whole currency hedging process is very complex, very technical, but the benefit to currency hedging is very straightforward. And that is when you hedge your currency, you are locking in the exchange rates today which means that you are removing from your portfolio the volatility that would come from currency changes, relative currency changes in the future. So the dollar changes relative to the yen, it’s a lot of volatility that can be added to your investment if you don’t hedge it.

Now, we generally suggest hedging on the non-US fixed income side and not so on the non-US equity side. The reason for that is I mentioned currency is volatile. Even a broad exposure to currency is volatile. It looks similar to volatility like you’d see in an equity market. So when you have currency volatility and equity volatility together in one portfolio, there is not a whole lot of difference in your average portfolio volatility. It doesn’t change anything to have that currency volatility in there.

The fixed income markets are much more stable. So, a non-US fixed income broad market exposure is pretty stable. If you add currency volatility to that kind of investment, you basically end up with an investment in currency. It really overwhelms your fixed income investment. So, in the non-US fixed income markets, we suggest that you hedge that away.

Akweli Parker: Got it.

Bryan Lewis: And that’s to the point too. If you take a step back when you talk to a client about the asset allocation, right? So, we want you to take the risk on the stock side not with the bonds, right? We want to mitigate as much risk with the bonds. They’re really there to provide stability as well as for investors that need income. Obviously, yields are low, but they still serve a purpose in really being more of a safety net. So, we don’t want to take any unnecessary risks there unless we absolutely have to. Let’s focus on doing that on the stock side.

Important information

All investing is subject to risk, including the loss of the money you invest.