If you’ve turned on the news lately, you’ve probably seen that the US stock market is going up, and up, and up.
But that’s not what everyone is seeing when they log into their brokerage accounts. If you’re investing in a well-diversified portfolio, you’ve likely noticed that your portfolio isn’t gaining as much as the US market is.
That’s because when you diversify, you’re investing in various different parts of the market that may not be performing as well as the US stock market is. And that’s fine.
It’s important to remember that, depending on your investment time frame, the short-term isn’t important. It’s what happens over the long-term that matters most. If that’s not true for you then a diversified portfolio may not be what you are looking for.
A lot of long-term investors will try tune out short-term market fluctuations in order to reap long-term returns.
A little background into diversification.
Diversification means you don’t just own a lot of different asset classes– property, shares, fixed interest–but you also own those asset classes in other countries, too. That’s to de-risk your portfolio in the case that a specific country's economy goes down.
So, when you’re diversified across borders, your returns are affected not only by how well the investments do themselves, but also how well your currency does against the currency of other countries (depending on whether your investments are in that country’s currency or not).
Imagine you own a fund that tracks the S&P 500 index, and the fund is in US dollars.
Now let’s say that the US dollar went up in value by 10% against the Australian dollar. Even if the fund’s value stayed flat, your investment would be up 10% because your US dollars (that are in the S&P 500 fund) would be able to buy 10% more Australian dollars than before.
Investing in foreign assets (and by association, foreign currency) is a way to get more diversification into your portfolio. Like any other investment, sometimes it will help, and sometimes it will hurt.
Why fluctuations aren't a huge issue.
It is possible to reduce the impact of fluctuations in exchange rates on your investments by something called currency hedging.
But by setting up a hedge, you also forgo any profits if the movement in the exchange rate is favourable. Like the example above.
Yes, you can hedge all your investments, but just like investing in the same market may not be a good idea, holding all your investments in the same currency may not be wise.
There’s often a price to pay when you hedge your bets.
When it comes to investing, it can be more expensive (and often not more effective) to currency hedge. Funds that do currency hedging often charge higher management fees to offset the risk of currency fluctuations.
In the end, foreign currency is another source of diversification in your portfolio, and like any other position you hold, it can both help, and hurt your returns.
No one can give you an accurate prediction of what the future will look like. It’s often your time in the market, not you timing the market, that gives you the greatest opportunity for good long-term results.
That’s why we’re so focused on the long-term, and not short-term fluctuations in price. It’s easy to feel frustrated when there is little to no progress in your portfolio, but the market is on the run. But it’s important to apply some second-level thinking and think about the benefits of diversification in your portfolio.
Remember that the same diversification that limits your upside also limits your downside. And when the market turns, you may be quite happy with the exact same mix of assets that you didn’t like before.