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Even with an occasional look at the headlines, you’re likely to see that the pound changes value regularly. Vaguely, you may think this affects you somehow – but how exactly? Naturally, if the pound lessens in value against other currencies then it means your overseas holiday is likely to be more expensive (since a pound “buys” fewer Euros, dollars etc.). Yet the changing exchange rate can affect investors as well.
In this article, our team here at Elmfield Financial Planning in Padiham, Burnley, Lancashire shares how Sterling fluctuations can affect a portfolio – and whether this should lead investors to be concerned. We hope you find this content useful. If you’d like to speak to an independent financial adviser then you can reach us via:
T: 01282 772938
How currency fluctuations affect investments
Investors (and those with pensions) may be aware that at least some of their portfolio is likely to be invested overseas – e.g. in a fund tracking the S&P 500, which itself invests in U.S.-based companies like Facebook, AT&T Baker Hughes. If you are an investor in the UK, therefore, you likely need to use pound Sterling to buy shares in these companies – which means converting your pounds into dollars.
This, of course, is affected by the exchange rate. Suppose that the U.S. dollar weakens against the pound by 5%. Whilst the stock market prices themselves may not change, the effect is a 5% reduction in the value of your U.S. equities when you want to convert them to pounds (i.e. the currency you use to live on here in the UK!). Conversely, imagine the opposite occurs – the pound falls by 5% against the dollar. In this case, your U.S.-based equities would rise 5% in value when you change them into pounds.
For a U.S.-based investor putting his/her money into domestic equities, currency risk is nothing to worry (or get excited) about. For a UK-based investor, however, currency fluctuations matter. The same is true, by the way, for an investor in the U.S. wanting to invest in the UK – or any part of the world, for that matter.
Currency fluctuations have another effect, moreover. If the pound rises in value then this makes foreign goods and services more affordable to Britons. If a UK company gets its supplies or raw materials from overseas, therefore, then it will likely pay less for them – leading to an increase in profits. However, a stronger pound may not be great news for UK-based manufacturers and overseas product suppliers – since their goods become costlier for foreign buyers.
Implications for investment strategy
The inevitable volatility in currency values may lead more “risk averse” investors to want to not invest overseas at all – even in “lower risk” assets such as U.S. Treasury bonds. Yet keeping all of your investments at home comes with its own risks – i.e. excessive damage to your portfolio if the national economy crashes (and other parts of the world fare better). The reality, of course, is that all things are never equal in financial markets.
For instance, the UK-based FTSE 100 – which comprises the 100 largest firms in the country – represents revenue which is overwhelmingly generated abroad (70%). As such, investing solely in this index would not protect an investor completely from currency risk. After all, a rising pound would likely mean lower profits for these companies since their goods become more expensive in U.S. dollars – which could hurt UK dividend investors in particular.
It’s important to speak with a financial adviser if you are concerned about currency risk in your portfolio. The implications are likely to differ depending on your risk appetite, your investment horizon and financial goals. For instance, longer-term investors looking to build a retirement fund over a 30+ year period may have less to fear from currency risk. After all, many studies have shown that this risk lowers the longer the investment horizon is stretched out. However, if you’re looking to draw down from your portfolio soon (e.g. those approaching retirement), then you will likely want to explore strategies that “dampen” the volatility in your portfolio.
For instance, those in the latter group may wish to consider dividing their overseas assets so they are held in different currencies. This can lead to a natural “hedging” as rising currencies are offset by falling ones. Another strategy on offer is to try and hedge currency risk out of the bond allocation in your portfolio, since many investors include these to mitigate the volatility typically seen in their stock market investments (equities). One way to do this would be to invest in UK government bonds (gilts) which are denominated in pound sterling.
Currency risk is one of the many risks that investors must consider when building and keeping the value of a portfolio – along with others such as market risk, liquidity risk and inflation risk.
If you are interested in starting a conversation about your own financial plan or investments then we’d love to hear from you. Please contact us to arrange a free, no-commitment consultation with a member of our team here at Elmfield Financial Planning in Padiham, Burnley, Lancashire.
Reach us via:
T: 01282 772938