Currency Conversion

Currency Conversion is the process of exchanging one country's currency for another. Think of it as the financial equivalent of translating a language. For international investors, it’s a fundamental, everyday transaction. If you're a European investor wanting to buy stocks in Apple, you can't just pay in euros; you need to convert them to US dollars first. This exchange happens at a specific exchange rate, which is the price of one currency expressed in terms of another. This rate is in constant flux, influenced by everything from national interest rates and inflation to economic stability and geopolitical events. Therefore, currency conversion isn't just a simple administrative step; it introduces a layer of both risk and opportunity to your global investments. Understanding how it works, and especially the costs involved, is crucial for anyone looking to build a resilient, worldwide portfolio.

Before you can invest abroad, you need the right money. This conversion process has a few key components you should be familiar with.

The exchange rate is simply the price you pay for a foreign currency. For example, if the EUR/USD exchange rate is 1.08, it means you need $1.08 to buy €1.00. However, it's not quite that simple. Institutions don't handle conversions for free; they make their money on the bid-ask spread.

• The 'Ask' Price: This is the rate at which a bank or broker will sell a currency to you. For example, they might sell you €1.00 for $1.08.
• The 'Bid' Price: This is the rate at which they will buy a currency from you. They might buy €1.00 from you for only $1.075.

That tiny difference—in this case, half a cent—is the spread. It's their profit for providing the service. While it seems small, this cost can add up significantly across many transactions or large investments.

For most ordinary investors, currency conversion happens automatically in the background through their brokerage account. When you place an order to buy a stock listed in London, your broker converts the necessary amount of your home currency (e.g., dollars or euros) into British pounds to complete the purchase. The same thing happens in reverse when you sell the stock or receive dividends in a foreign currency. You can also perform conversions through your bank or specialized online currency services, but for investing, your broker is typically the most convenient gateway.

For a value investor, the focus is always on the underlying value of a business, not on market noise. Currency fluctuations are a prime example of such noise, but they can't be ignored entirely.

Currency risk (also known as exchange-rate risk) is the danger that a change in exchange rates will reduce your investment returns when you convert them back to your home currency. Let's imagine an American investor buys shares in a fantastic French company for €10,000.

1. At the time of purchase, the exchange rate is $1.10 / €1.00, so the investment costs $11,000.
2. A year later, the stock has performed brilliantly, rising 20% to €12,000. A great result!
3. However, during that year, the euro has weakened against the dollar, and the new exchange rate is $1.00 / €1.00.
4. When the investor sells the shares and converts the €12,000 back, they receive only $12,000.

While the stock gained 20% in euro terms, the investor's actual return in dollar terms was only about 9% ($1,000 profit on an $11,000 investment). The currency movement “stole” more than half of the stock's gain. Of course, this can also work in your favor, amplifying your returns if the foreign currency strengthens.

Hedging is a strategy to protect against unfavorable currency movements, essentially like buying insurance. Investors can do this using complex financial instruments or, more simply, by buying “currency-hedged” funds or ETFs. However, many legendary value investors, including Warren Buffett, generally avoid systematic hedging. Their reasoning is twofold:

1. Long-Term Perspective: Over many years, currency fluctuations often even out. The cost of continuously hedging can act as a permanent drag on your returns, nibbling away at your long-term compound growth.
2. Focus on the Business: A truly great global business (like Coca-Cola or Nestlé) generates revenue in dozens of currencies. These companies have their own professional treasury departments managing currency risk. Owning them is, in itself, a form of diversification against the woes of any single currency. The value investor's job is to correctly value the business, not to make bets on the foreign exchange market.

• Mind the Fees: Always check what spread or commission your broker charges for currency conversion. A seemingly “free” conversion is often paid for via a wide bid-ask spread. High fees are a guaranteed loss that comes directly out of your pocket.
• Think in Decades, Not Days: Don't let short-term currency forecasts sway your decision to buy a wonderful business at a fair price. The quality of the company and its long-term earning power are far more important drivers of your ultimate return.
• Diversify Globally: Owning great businesses in different countries with different currencies is a powerful, common-sense defense. If the US dollar weakens, your European and Asian holdings will likely become more valuable in dollar terms, providing a natural buffer.