Investments 101: How Exchange Rates Influence Your Investment Portfolio

How exchange rates influence your investment portfolio

Last week I wrote about country ratings and the impact they have on the economy and your portfolio.

This also has an immediate impact on exchange rates.

As a traveller, I always feel the change in exchange rates instantly.

I remember the first time the finance minister in South Africa was replaced - I was living in Goa, India.

Up until that moment ZAR1 would give me Rs5, but then suddenly overnight ZAR1 could only get me Rs4. I was super upset.

Now in Dubai, something similar is happening, only now it’s crazier because the currency here is stronger and it’s one of the most expensive cities in the world.

 

Okay, so what the heck causes currency fluctuations?

 

Let's start with investor confidence.

Believe it or not - confidence, as in the emotion, is a huge part of economics.

When a country (like South Africa) gets downgraded (or does anything investors don’t agree with), investors lose confidence in the government to meet their financial obligations or run the country well.

That immediately sends investors and speculators (people who trade currency to make money and add another layer of volatility to the mix) into panic and they start selling the country's currency because that’s one of the most liquid assets.

When too many people start to sell the currency, it creates a situation where the supply of that currency outweighs the demand, which causes the value of the currency to drop.

Because as we know; an oversupply of anything leads to a drop in price.

At the same time all this is happening the country's government bonds suddenly become unattractive because of the perceived risk and the drop in currency fuels this perception.

Government bonds drop in price (because when people doubt your quality you have to drop prices to entice them to buy).

Suddenly imports (and traveling) become expensive which means the price of goods goes up because it costs companies more money to buy these foreign goods and get them to the stores so we can buy them.  

And because companies need to make a profit, increased costs lead to an increase in prices.

Oil is charged in US Dollars. when the Rand drops, a barrel of oil suddenly costs more and transporting all these products around the country costs companies more money, so they're forced to increase their prices even more.

So now you have a situation of higher prices (this is what inflation is) and a higher unemployment rate. Basically an economic nightmare brought on by investor confidence (an emotion).

 

It's not all bad...because: Exports

 

Here's where economics becomes really Buddhist for me - every bad side has a good side, type thing.

I remember reading "Gone with the Wind" at 16 and Rhett Butler explaining to Scarlett that more fortunes are made during the breakdown of an economy than in the build-up.

My 16 year old self was fascinated and would spend hours wondering how that could be. So of course I had to study economics and finance to understand this.

When a currency depreciates (falls), it means any good or service sold in that currency becomes cheaper, even if prices do increase for everyone else. 

Smart companies will exploit this and start selling more products and services abroad, which leads to an increase in exports.

So when imports decrease, exports will increase in South Africa and some companies will start to increase revenues and profits and start hiring again.

If you’ve invested in these companies, your investment portfolio will increase in value.

To be fair, this isn't about smart companies, it also depends on the industry the company operates in. Some companies may be smart but the industry they operate in, can’t exploit a decreasing currency.

But maybe this creates a space for entrepreneurs to sell great products and services to people abroad?

What's expensive in a country with a depreciating currency suddenly seems super affordable to people in a country with a strong or appreciating currency. So think out the box.

Some people will also choose to work in different jobs abroad and use the depreciation currency to their advantage, send money home and build up investment portfolios faster.

So in the long run things do turn around - some companies will come out on top and others will fail.

 

So what does this mean for your portfolio?

 

It means you have to understand the companies and industries you’ve invested in before making any decisions.

Can a depreciating currency benefit the company's industry in any way?

Does the company have an international client base?

What are the CEO's values?

How does the board of directors and management think and handle a financial crisis?

Does the company culture emphasize innovation and change?

Is management emotionally intelligent - do they keep a level head? Are they long term and bigger picture focused in times of crisis?

Talk to your financial advisor but also make sure your financial advisor is thinking long term and understands the economic implications.

I hope this is helping you see why investments sometimes feel like a gamble and why it’s more important for us to remain calm as we make economic decisions until we have more information.

Let me know your thoughts in the comments section below. Are you seeing some opportunities?