Although most of the news that you hear about stocks involves American companies, the total value of American stocks now makes up just 31% of the total value of all publicly-traded stocks in the world.  And the U.S. currently represents a much smaller fraction of the world’s economic growth, which is a major underlying force which drives the growth in stock values.  Based on those percentages, you may wonder why 69%–or more–of your portfolio isn’t invested overseas, with the bulk of it in the emerging market countries that are driving today’s global growth engine.

One answer is currency risk.  Not only do stock prices bounce around; so too do the values of the dollar, yen, pound, euro and Polish zloty.  The chart below shows the constant changes in the value of the U.S. dollar against a basket of foreign currencies since the late 1960s.  If you overlay this volatility on the normal volatility of foreign stock prices, you get an amplifying effect–more price movements in the value of your investments.  Of course, holding some international stocks will also tend to dampen the volatility of your overall portfolio, so there’s a tradeoff.  But a portfolio that is heavily invested overseas is likely to provide a bumpier ride than domestic stocks, simply because the foreign stocks have an extra contributor to their volatility.

To see how currency movements can affect the value of your stocks, imagine that on April 8, 2009, you bought one share of a Japanese company whose shares happened to be trading at 5,000 yen on the Tokyo exchange.  At that time, the currency markets were trading 100 yen to the dollar, so your share of stock cost $50 in American currency (5,000/100=50).  Three years later, on April 30, 2012, you notice that the value of the stock has fallen to 4,500 yen, a 10% decline.  Time to sell this dog!

So you sell the stock, and on your next statement, you discover that you made a 12.5% profit on what you thought was a losing investment.  How did that happen?  While you were holding the stock, there had been a decline in the value of the dollar (or a rise in the value of the yen; they are, of course, the same thing), so that last April, each dollar would only purchase 80 yen.  Divide the 4,500 yen share price by 80 yen to the dollar and you received back $56.25 on the sale of your stock–a 12.5% profit.

Of course, it can also work the other way.  Suppose the dollar had increased in value over the same time period.  If the dollar had strengthened to the point where you could buy 120 yen on the currency markets, then your Japanese stock sale would have yielded just $37.50–a 25% loss, even though the stock value in yen had only fallen 10%.

Every currency has its own fluctuations, and some are fairly dramatic.  The aforementioned Polish zloty was trading at two to the dollar in the Summer of 2008, but nine months later, your dollar could have purchased 3.7 zlotys.  After a rollercoaster ride, zlotys are currently trading around three to the dollar.  The euro started life roughly at par with the dollar, and is now trading at around .67 euros to the dollar.

If you look at the dollar chart again, you see that the greenback’s value is loosely tied to U.S. interest rates.  When Treasury yields were astronomically high during the 1980s, there was high demand for dollars, and the value was high relative to other currencies.  As interest rates have fallen, so too has the dollar.  There are other complicating factors due to the fact that the dollar also happens to be the world’s reserve currency, and also because it is backed by the largest, wealthiest economy in the world.  Notice the spike during the crisis of 2008, when people around the world were frightened by the potential collapse of the capitalist system (thank you Wall Street), and America was seen as a safe place to park your wealth until things sorted themselves out.

What will the dollar do in the future?  Who knows?  All we know for sure is that it is hard to imagine interest rates going down much further than they are today.  If interest rates bounce back up, the dollar value of foreign stocks owned by Americans could drop in dollar terms, even if they hold steady for investors in their own country.  At the same time, those foreign stocks will be cheaper to invest in.

And in some cases, there will be no effect.  Certain mutual funds that invest abroad routinely hedge their currency risk, so that whatever the dollar does, it doesn’t affect the value of the fund’s foreign stock holdings.  Hedging adds to their investment costs, but it also means you get roughly the same investment gains or losses that the locals get, without worrying about the additional roller coaster ride that currency markets are providing.

Sources:

http://www.oanda.com/currency/historical-rates/

http://www.tradingeconomics.com/united-states/currency

http://internationalinvest.about.com/od/gettingstarted/a/currencyeffect.htm