The basic premise of investing is to generate returns on investments via cash distributions or capital appreciation. The investor requires a return for his capital risked, and this investment capital (from savings) can fund initiatives that better society. Profits captured by an investor can either be spent or reinvested (saved). Irrespective of where these funds are deployed, the investor’s home market and currency dictate the real purchasing power of that investor.
Purchasing power, and its parity across financial borders, matters a great deal to me. I believe that the impact and exposure of an investor’s home market and currency should be considered when purchasing/selling various securities such as stocks & paired trades and currencies & commodities. More broadly, this concept should permeate the portfolio modus operandi. This may be easiest to explain through some examples:
- A domestic (US) investor invests alongside his domestic stock market (S&P 500). Very simply, his nominal return is equal to the stock market’s performance. In financial jargon, the investor’s portfolio lies on the capital market line and has a beta equal to one.
- Perhaps the investor, like many investors, ventures into individual stocks. Now, his nominal return is measured as the performance of these individual stocks relative to the market’s performance. So if the investor’s stocks rise 8% while the market appreciates 11%, the investor has lost power—that is, his returns no longer enable him to consume or save as much as other investors can consume or save.
- Now let’s take a step back and throw a slight variation into this. Let’s say that instead of a domestic investor investing, a foreign investor (European) owns the S&P 500. The foreigner’s nominal return is the same as the domestic investor; his return is equivalent to the market’s performance (and the portfolio has a beta equal to one). However, since a foreigner uses his returns to consume in his own country, he must convert his gains into his home currency (euro). The foreigner’s real return is equal to the S&P 500 plus the currency differential between the US Dollar and euro. Thus, if the euro depreciates relative to the US Dollar, our two investors will have different real returns. (This example also works in reverse when a domestic investor, such as an American, invests in a foreign market index, such as the Nikkei, DAX, or FTSE).
- Combining these two previous examples is a scenario when a foreign investor (European) owns individual stocks in a domestic market (US). Here, a foreigner’s real return is measured as the performance of his individual stocks relative to the market plus the currency differential. How an investor performs relative to his peers determines incremental power gained or lost, and how an investor’s currency performs further dictates what his investment returns can buy.
Since market performance and currency performance are both global phenomena, I argue that this last example is where most investors lie, even though they may not recognize it. Since individual stocks generally have positive correlation to the stock market, an investor who invests in individual securities is accepting market exposure. Just think—if you purchase stock ABC and the stock market falls, ABC is not going to rise just because you want it to; ABC will tend to fall when the market falls and rise when the market rises. Furthermore, every stock is priced in a currency. Therefore every stock purchase irrespective of its domestic market is an exposure to currency risk. By this nature, anyone who owns or transacts in any currency is exposed to that currency’s value.
Clearly I’m not rewriting the rules of financial theory here. What I do resolve is that the application of this concept implies that every stock purchase should be done in consideration of expected market performance and expected currency performance. Paired trades and currency hedges are not uncommon occurrences, yet I believe combining the two is a necessary concern that has failed to germinate among the investment community. More broadly, construction of a portfolio requires a stock market thesis and requires a currency thesis in order to evaluate the performance power of real returns. Only when an investor measures real stock performance relative to real market performance can the purchasing power of real returns be determined.