Diversification is the best way to reduce portfolio risk. It has long been understood that spreading your capital wisely can save you from unexpected asset deterioration, but exactly how to do that needs to be reconsidered.
The modern investor has a wealth of new tools to achieve real diversification. Small investors are encouraged to spread their portfolios across a range of stocks and bonds. Small caps, mid caps, large caps, value, growth, short and long-term Treasuries, and municipal bonds have been the staple of a diversified portfolio. Well, times have changed and so too should your notions of eggs and baskets.
It’s easier than ever to pick up the same kinds of exotic investments as the most sophisticated hedge fund in days of yore. Regular people can now include all types of commodities (from agricultural to energy and everything in between), currencies, and select stock sectors in their portfolios simply by purchasing exchange-traded funds (ETF’s).
Currencies, in particular, offer individuals a powerful alternative for hedging inflation and the decline of the US dollar, and adding a new level of diversification to offset adverse movements in stocks and bonds.
Portfolio theory suggests that adding minimally or negatively correlated assets to your portfolio can decrease overall portfolio variance, or risk.
Analyzing stock indexes in relation to major world currencies shows that Swiss Franc, Japanese Yen, and Swedish Krona have negative correlations to US stocks, while Mexican Peso, Australian Dollar, and Canadian Dollar are positively correlated. To get the most out of diversifying a US stock portfolio, it would be advantageous to include the former and exclude the latter. However, there are other reasons to invest in currencies, such as hedging declines in the US dollar.
Including the negatively correlated currencies over the last year would have seen between 12% and 17% capital gains. This is due merely to appreciation relative to the US dollar. In addition to relative currency gains, each ETF offers dividends representative of each countries interest rates.
There are multiple consderations in portfolio theory, but applying the basics can have far reaching benefits. Those concerned with dividends should hold the highest yielding ETF’s, which include British pound, Australian dollar, and Mexican peso. On the flip side, income investors should avoid Swiss Franc and Japanese Yen.
In a world of increasing energy and food price inflation, you can see how important it is to hedge these risks. Currency ETF’s offer such an opportunity; exposing investors to relativer currency price movements, as well as variable income opportunities from taking advantage of interest rate disparities in foreign markets.