Why Is Currency Risk Bad?

A reader writes in, asking:

“I don’t see why currency risk is necessarily bad. Sure, sometimes the dollar will increase in value, making your foreign investments worth less. But sometimes the opposite will happen. It seems like, on net, this should neither help nor hurt over an extended period.”

As a bit of background information: “Currency risk” refers to the volatility that foreign investments (such as international stock funds) experience as a result of fluctuating exchange rates. For example, your international holdings will decline in value if the dollar increases in value relative to the currencies in which your foreign holdings are denominated. Currency risk is often cited as a reason for underweighting international stocks and bonds relative to the part of the overall world market that they make up.

This reader is correct that currency risk should, on average, neither increase nor decrease your returns. And that’s precisely why it’s an undesirable risk. After all, there are an assortment of risks that do increase the expected return of your portfolio: increasing your equity allocation, increasing the duration of your bond holdings, reducing the average credit rating of your bond holdings, etc.

So, if there’s a certain level of overall risk that you can tolerate, you might as well get as much expected return for that level of risk as you can. In other words, why take on any risks for which you would not expect to be compensated? (This is also, by the way, the reason that holding a concentrated portfolio of individual stocks does not typically make sense. It increases the risk relative to a diversified stock portfolio, yet it does not increase expected return.)

To be clear, the point here isn’t that including an international allocation is a bad idea. It isn’t. Most experts agree that including international stocks in your portfolio is still desirable, because it increases the total number of stocks that you hold, which improves diversification, and because it adds a component that has less-than-perfect correlation to U.S. stocks while still having similar expected returns. The point is simply that it likely makes sense to hold a smaller allocation to international stocks (and bonds) than you would if currency risk did not exist.