Notes on Foreign Exchange

A reader recently asked my opinion on foreign exchange (forex). It depends, really. Banking on short-term fluctuations or active trading is financial suicide. But as a mechanism for parking a portion of one's excess cash not needed in the medium term (6 months to a year) it's not a bad idea and I actually encourage it.

Short Term Speculation

Anyone engaged in day trading or active trading in forex is losing money, necessarily. Forex is a zero-sum game for investors -- one side must lose in order for another one to win. But there's more: spreads, taxes, and commissions make it necessarily a losing game.

Not only that, but foreign exchange rates are thought to be even harder to predict than short-term stock movements. If you thought it was hard to value a company, imagine a country or a group of countries as is the case with the Euro. There's just too much going on -- policy setting, politics, lobbying, international interference, international trades, changing laws and even wars and natural disasters.

Stay away from short-term speculation on forex.

Medium-term cash parking

If you have excess cash (and you should, for your emergency funds), then diversifying away from your local currency is like buying insurance against three things:

  1. Government actions (jurisdictional diversification)
  2. Inflation
  3. Major catastrophes (natural or man-made)

Government action protection only works if you pick currencies from countries with a reasonable political history. It protects you from arbitrary actions taken by a governments that could adversely affect the currency, such as import taxes, interest rates, or even outright confiscation.

Inflation is listed again separately from government action because it's such a common threat. It's the invisible tax. A basket of currencies can help mask the effect of a single inflationary country devaluing your hard-earned cash.

And of course, if something terrible happens to a country, having some exposure to other currencies can mitigate some of the negative effects.

I currently don't put a lot of faith in the US dollar, so I believe it makes sense to have some exposure to other currencies (gold was discussed here).

Guidelines for investing in foreign currencies

So, what do I recommend? First, when possible, tilt your allocation towards currencies that earn some real (after inflation) yields. The Swiss Franc right now yields 0%, while the Australian dollar yields over 3%. You might as well get paid to wait.

Second, pick countries with a history of maintaining their stability and buying power. In this case, the Swiss Franc is a good option and it is also partially-backed by gold.

Third, choosing currencies whose countries have lots of varied natural resources may provide some comfort about the currency's attractiveness in international markets. Some options that come to mind are Australia, Canada, Brazil and South Africa.

Current opportunities

My current cash diversification is pretty bad and I don't recommend anyone follow it. Given what I just wrote, I will follow my own advice and diversify further. But just because you asked, my cash reserves are currently split as follows: 12% in Brazilian Reais, 6% in Australian Dollars, 4% in Canadian Dollars and another 4% in the South African Rand. The other 74% are still shamelessly in US dollars (in my defense though, I do have international stocks traded directly in foreign stock exchanges in their native currencies).

Until recently I was recommending CDs backed by a basket of foreign currencies, but I found that option to be cumbersome and not very fee-friendly or transparent so now I'm sticking with currency ETFs such as FXA or direct investment in the target countries (to take to the extreme the jurisdictional diversification).

FXA, by the way, is down 3% from last year's averages and yielding more than 3%.

Disclosures: Long FXA.

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