Foreign Exchange Risk

Foreign Exchange Risk (also known as 'FX Risk' or 'Currency Risk') is the potential for an investment's value to decrease due to changes in the relative value of currencies. Imagine you're an American investor buying shares in a fantastic French company. You pay in U.S. dollars, which are converted to euros to make the purchase. Later, you sell your shares for a handsome profit… in euros. But what if, during that time, the euro has weakened against the dollar? When you convert your euro profit back into dollars, you might find your return is much smaller than you expected, or even gone entirely. This is foreign exchange risk in a nutshell. It’s an extra layer of uncertainty that comes with crossing borders, reminding us that the return we ultimately care about is the one in our home currency. It affects not just stocks, but any asset denominated in a foreign currency, from bonds to real estate.

Let's make this real with a simple story. Meet Jane, a U.S. investor. She discovers what she believes is a brilliant, undervalued German car company, “Auto Wunderbar.”

• The Purchase: Jane buys 100 shares of Auto Wunderbar at €100 per share. Her total investment is €10,000. On that day, the exchange rate is $1.20 per euro (€1 = $1.20). So, her investment costs her $12,000 (€10,000 x 1.20).
• The Good News: A year later, Jane's analysis proves correct! The stock has soared to €115 per share. Her holding is now worth €11,500, a solid 15% gain in euro terms. She decides to sell and take her profit.
• The Hidden Twist: During that year, however, economic factors like changing interest rates and balance of payments data have caused the euro to weaken against the dollar. The new exchange rate is now €1 = $1.05.
• The Reality Check: When Jane converts her €11,500 back to her home currency, she receives just $12,075 (€11,500 x 1.05).

Her initial $12,000 investment grew to only $12,075. Her total return in dollars is a measly 0.625%. The 15% stock gain was almost completely wiped out by a 12.5% loss on the currency exchange. This is the painful bite of FX risk. Of course, it can also work in your favor—if the euro had strengthened, it would have supercharged her returns. But as investors, we must be prepared for the downside.

So, how should a prudent value investor approach this tricky variable? The legendary Warren Buffett offers a clear guide: for the most part, don't worry about it. Buffett's company, Berkshire Hathaway, invests globally but generally does not try to predict or insure against currency movements. The reasoning is pure value investing wisdom:

• Focus on the Business: Your primary job is to find wonderful businesses at fair prices. The long-term performance of a superior company will be driven by its earnings power, competitive advantages, and management skill—factors that should vastly outweigh currency noise over decades. Trying to guess short-term currency swings is speculation, not investing.
• Long-Term Arbitrage: Over the very long run, currency exchange rates should theoretically adjust to reflect the relative purchasing power of the currencies. While volatile in the short term, these fluctuations tend to even out. An investor with a multi-decade time horizon can afford to ride out these waves.
• In-Built Corporate Hedging: Many great international companies (think Nestlé, Diageo, or Unilever) are a natural hedge against FX risk. They earn revenues and incur costs in dozens of different currencies. Their global diversification provides a built-in buffer, smoothing out the impact of any single currency's fluctuations on their bottom line. A capable management team is already managing its own corporate currency exposure as part of running the business.

If you're worried about FX risk, you might be tempted to use hedging. Hedging is like buying insurance. An investor can use financial instruments like currency forwards, futures, or options to lock in an exchange rate and protect against adverse movements. For the vast majority of ordinary investors, this is a bad idea. Here's why:

• It Costs Money: Hedging isn't free. The commissions, fees, and built-in spreads act as a constant drag on your returns. You start every year with a small, guaranteed loss.
• It's Complicated: Effectively managing a hedging strategy requires significant expertise and attention. It’s a field for professionals, and it's very easy for an amateur to get it wrong.
• It Caps Your Upside: A hedge protects you from losses, but it also prevents you from gaining if the currency moves in your favor. If Jane had hedged and the euro strengthened, her “insurance” would have turned into a costly mistake that limited her profits.

Foreign exchange risk is a real and unavoidable part of international investing. However, for a long-term value investor, it should be treated as background noise, not the main event. Your strategy should be simple:

1. Acknowledge It, But Don't Obsess: Understand that currency fluctuations will create volatility in your foreign holdings' reported value.
2. Think in Decades, Not Days: The longer your time horizon, the less impact short-term currency swings will have on your ultimate returns.
3. Prioritize Business Quality: Your best defense against any risk, including FX risk, is owning a portfolio of excellent, well-managed businesses with durable competitive advantages and strong intrinsic value. Their fundamental performance is what will build your wealth over the long haul.