Pride, predictions and a falling dollar

While Olympic athletes have done their bit for national pride this week our currency is proving a fickle friend to investors.

The Australian dollar is down 11% from its peak at $US0.98 in July 2008.

Emotionally that feels like a bad result - it seems it was only a few short weeks ago we were spruiking the Aussie dollar was going to hit parity with a (albeit sinking) US dollar.

The little Aussie battler was about to stand toe-to-toe with what is effectively the world's reserve currency. There were even reports of "parity parties" being planned for when the Australian dollar broke through the magical value barrier with the US - the sort of party understandable on the pool deck in Beijing if our swim team outperforms the US but perhaps a little out of place in the hard-headed world of international currency trading.

For investors the currency's wild swings probably underscore the volatility of investment markets all around the world. But there are two key points to keep in perspective when trying to make sense of the currency moves.

First is that a falling dollar is good news for some investors, not to mention all those Australian companies that earn money by exporting.

For long-suffering international share investors who had not hedged their currency risk in recent years the dollar's slide is good news. The fall in the value of our dollar means the value of assets held in overseas markets gets a boost from the currency effect.

The second - and probably most important - is that when it comes to predictions of currency moves you are probably as well off reading your horoscope as trying to glean useful insights from the pontifications of seriously smart economists on where the exchange rate is heading.

As recently as May leading bank economists were predicting parity for our dollar versus the US currency by year end. Just last month forecasts had the Australian dollar staying above $US0.92 cents for the rest of the year. That is neither a particularly long-range forecast nor that long ago.

It simply illustrates how dangerous it is to predict the future - particularly if you are investing hard-earned savings on the back of it.

This is not meant to disparage the efforts or professionalism of economists it just goes to show that even with highly sophisticated financial models the forecast of currency value is just that - a forecast of the future based on historical information.

The impact for investors has been dramatic in the past five years. Consider the returns from the MSCI World (ex-Australia) international shares index. The index has delivered 2.8% growth over the five-year period to the end of July. If you invested in the same international share index but hedged away the currency risk the return was a much healthier 11.07%. That can be achieved by opting for the hedged version of an international share fund that most fund managers offer.

The past six months when markets have been extremely volatile underlines the point. The international share index is down 10% on an unhedged basis while the investor who had opted to hedge the currency is seeing a negative return of half that at -4.5%
This is where investment theory and investor reality meet. The returns of recent years tells us hedging currency risk was a good idea - it does not guarantee the same will be true going forward. In fact long-range market analysis and research says currency impacts are largely neutral over the long-term. But by long-term we are talking 20 to 30 years.

The past year has provided many tough lessons for investors around risks. Currency risk is simply one that needs to be considered. Given Australia's size in terms of world sharemarkets diversification across international shares makes fundamentally good sense.

But investors need to be aware that the dollar can be a real party animal and treat it with the respect it deserves.