A READER from Europe writes, “In your book, How to Think About Money, you suggest a U.S. investor might have 40% in U.S. stocks and 20% in non-U.S. stocks [plus 40% in U.S. bonds]. I understand that this tilt toward U.S. stocks reflects the fact that U.S. readers should keep most of their portfolio in dollar-denominated investments to avoid currency exchange risk. Since I live in Europe and I will retire in Euroland, would you have a rule of thumb on what proportion to allocate to euro-denominated investments?”
My response: “As I see it, you need to juggle two competing objectives: 1) You want investments denominated in your home currency, so money you plan to spend soon isn’t subject to currency risk; and 2) You don’t want to invest too much in your home stock market, because of the risk it could be the next Japan, which has lost half its value over the past 27 years.
“I think you can largely solve this problem by keeping all your bond exposure in euros, while holding a globally diversified stock portfolio. As you approach retirement, you’ll want to increase your bond exposure—and that will not only lower your portfolio’s riskiness, as reflected in your stock-bond mix, but also reduce your currency exposure. If that still leaves you with an uncomfortable amount of currency exposure, you might overweight Euroland stocks. Let’s say you’re retired and have 50% stocks and 50% bonds, with half the stocks in Euroland shares and all the bonds in euro-denominated securities. That means only 25% of your portfolio is invested outside the Euroland and hence subject to foreign exchange risk—a reasonable amount of currency risk for a retiree to have.”
The currency issue becomes trickier if you live in a small country that isn’t part of a currency bloc like the euro. In that case, investing in stock and bond funds that hedge currencies would likely make sense. That way, you can get broader diversification—without the added foreign-exchange risk.