The idea behind diversification is quite simple. It is the
fundamental principle behind multi-asset investing (which 7IM is a
firm believer in). Most investors have embraced it in one form or
another - spreading your investments across companies, sectors and
geographies reduces the likelihood of one chance event affecting
all of your holdings. An earthquake in California might hurt
Silicon Valley-based tech stocks, but have no impact at all on
German bonds, or the price of industrial copper.
The above appeals intuitively to almost everyone, and there are
very few investors now, whether advised or independent, who own a
concentrated portfolio of stocks. The famous exception is Warren
Buffet, who calls the process "di-worse-ification" as it gets in
the way of really getting to know a company's merits. Having said
that, even the Sage of Omaha admits that for 99.9% of people (ie.
unless youareWarren Buffet), broad and cheap tracker funds are the
So far so good. Yet many investors overlook a major factor in
their return - the impact of foreign currency exposure. It seems
screamingly obvious, but in order to invest abroad, you have to
convert your Sterling; before buying a share in a US company, you
first need the Dollars to do so!
Suddenly, along with exposure to the share price, there are
changes in exchange rates to consider - something which hugely
increases the complexity of a portfolio. Imagine owning a single UK
company - let's say Tesco. Adding a holding in something like BP
means there are two sources of return, depending on the performance
of the two shares. If we then add a position in Apple, we now have
to consider the share price movements of the three stocksplusthe
movement in the Dollar/Sterling exchange rate. Buying another
international equity such as Volkswagen (VW) adds another two
moving parts to the equation - VW's price plus the Euro
Some academics argue that over time, currency fluctuations tend
to even out, which may well be true over decades (although there is
some doubt about even that broad a statement). In the real world
though, failing to take currencies into account can change the
whole perspective on whether an investment was successful or
Looking at Japan over recent years provides an excellent
demonstration of the above. In December 2012, Shinzo Abe became
Prime Minister, winning a landslide election on a platform of
structural reform and economic growth. This was great for the
equity market, with the Topix index of Japanese companies rising
70% over the following two years.
However, one of the stimulus measures that Mr Abe introduced was
a loosening of monetary policy, which drastically weakened the Yen.
For a Sterling investor, this meant that the 70% return was reduced
to 27%. Over the same period, the FTSE 250 index of mid cap UK
companies returned 37%. So a UK investor may have correctly
identified the growth in the Japanese economy and invested
accordingly, yet after adjusting for currency they would have been
better off just buying their own local market!
Obviously, foreign currency can rise rather than fall too - over
the course of the 2008 crisis, the Dollar rose by more than 30%
against Sterling, so any US equities massively outperformed their
The point of the above discussion is not to argue for or against
foreign currency exposure - there is no consensus in the financial
world as to the correct approach (arguably having the ability to do
either is the ideal option). The main takeaway should be that when
diversifying your investment portfolio, it is important to
understand ALL of the additional risk that comes with such a move.
Having an additional, ignored variable can turn good decisions into
bad ones in a very short space of time.