Investing In Currencies On Foreign Exchange As An Essential Tool For Diversification Of A Long-Term Portfolio
In this day and age, conventional long-term investment in stocks, bonds, and mutual funds can no longer comprise 100% of one’s portfolio — simply because it can no longer protect the principal adequately. The world’s markets have become so interdependent that all asset classes are now very correlated. This means that they rise and fall together, fully exposing the investor to global risks. Diversification of one’s holdings has never been as important and hard to implement as it is now.
The way to achieve true diversification is to include currency investments and active trading strategies into one’s portfolio. Currency investment takes many forms, from the very conservative buy-and-hold of government bonds nominated in foreign currencies to short-term speculation on forex. Currencies rise and fall out of sync with stock markets. For example, while the Dow has lost 34% in 2008 (Jan 01 to Dec 31), the Japanese Yen gained 23% in the same time period. Of course, currencies can follow stocks as well. It is important to note that currency exchange rates are affected by different factors than stocks. A stock has a natural tendency to follow the company’s earnings. If the company grows its business, the stock price follows. Currency value does not depend on the health of a country’s economy as much as on the actions of the issuing central bank and inflation. Consequently, the main difference between stocks and currencies is that stocks in general can be expected to grow long-term, while currencies are all losing their purchasing power at different speeds, and their foreign exchange rates can change directions quickly.
Because of this, holding currencies for extended periods of time is more risky than implementing a short term active forex trading strategy. Gains and losses realized in currency trading do not necessarily depend on the direction of the market, but are determined by the strategy itself. For example, a strategy built to trade short in bear market rallies can perform exceptionally well in the current environment with the dollar — but more importantly, it will add a negatively correlated component to the portfolio. Brokers provide a number of ways to implement an active trading strategy, including highly automated forex online trading terminals that have the ability to automatically analyze the market and place orders.
While investing in currencies is necessary for asset diversification and provides many benefits, including protection from loss of the purchasing power of the dollar, it is also not something that should be undertaken lightly. Investing in currencies is not similar to the more conventional forms of investment, and certain skills must be developed in order to invest successfully. This is precisely the reason why investment in currency is not recommended to clients by mainstream financial advisors – they consider it best to be safe than sorry and, frankly, this advice is the best one for many people whose itch to get rich fast overcomes their ability to reason.
However, when used as a diversification and hedging tool rather than a high risk speculative instrument, forex trading has a legitimate place in a portfolio. It is easy to get a first hand impression — any broker will be happy to offer a free forex demo account for practice, without any obligations.
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