How Currency Exchange Rates Can Affect Your Investing Decisions

In this segment from Market Foolery, the team talks foreign currency and exchange rates as they relate to non-U.S. portfolios based on a question from a Foolish listener.

The core issue? When you invest in U.S. dollars and cash out in another currency, its gains against the dollar cut into your profits. But the team also notes there are very good reasons for Canadians to be in U.S. markets -- chief among them, the need for diversification that Canada's market is less able to provide. And there's a simple, long-term solution to mostly avoid the problem.

Chris Hill: Our email address is [email protected]. From Matt Saunders in Nestleton, Ontario. "I was hoping you could explain the effects of currency exchange on stock purchases. I'm in Canada and our dollar is quite low compared to the U.S. dollar. However, it wasn't too many years ago, we peaked a little higher than the U.S. dollar. My concern is that if I buy a U.S. company at this point and the dollar rises again, will that work against the value of the U.S. company that I purchased? Or does buying on the TSX compensate for that somehow? Thanks for all your help with this. P.S. please tell Steve Broido, we just made a trip to Orlando and had a great visit to an Olive Garden there. Definitely a fan." Steve will appreciate that, I'm sure.

Taylor Muckerman: Yeah. Thanks for listening all the way from Ontario. This was a question that we receive quite often in Stock Advisor Canada, Pro Canada, and now Dividend Investor Canada. We put a special report about this a couple years back. Over those couple years, not much has changed. Remain to see the Canadian dollar still trading below the U.S. dollar. I think right now, it's around $0.75 to the U.S. dollar. As you did mention earlier in the 2000s, the Canadian dollar did peak around $1.20 to the U.S. dollar. That ramp-up really did cramp Canadian investors' returns when you look at it, from investing in the U.S. dollar. When the Canadian dollar does appreciate, you lose a little bit there when you sell back into the Canadian market. So, what we generally tell our members to do is, A) we absolutely recommend investing in the U.S. market, because when you look at the Canadian market, about two-thirds of it relies on the energy, financials, and the materials sector, two very volatile sectors, in the energy and materials sector and then financials, really, the bulk of that is driven by the big banks, TD, Scotia, CIBC, BMO, and RBC. They're very highly concentrated if you don't move outside of the Canadian market. When you look at the largest sector in the U.S., IT, I think that's around almost 22% of the S&P, it's 2.7% of the S&P TSX. So, you're missing out on a lot of potential growth there. And less than 1% of the S&P TSX is healthcare. If you think about that, you're missing out on some huge potential growth there. It was a little higher, but Valeant obviously reduced the share of that overall market when that fell precipitously over the last couple years. 

But, the long-term average of the Canadian dollar to the U.S. dollar is right around $0.85. There's about 13% upside from where it is right now until it reaches the long-term average, I think we have information going back to 1971 on our site. That's over 30 to 40 years of data with the long-term average of $0.85 to the U.S. dollar. So, you're not far away from that. Compared to that $1.20 you saw in the early 2000s, we view that as a one-off event, especially with oil where it is these days, and the likelihood that remains subdued as compared to when it was over $100, which, coincidentally, timed very well with when it was peaking with the U.S. dollar there. So, we advocate people considering the Canadian dollar to the U.S. dollar exchange rate, but we don't say, "Just invest Canadian only." Put some dollars into a separate account, leave them there for the long-term so you don't have to pay the cost to exchange back and forth, because banks do charge for that. And you don't get charged if the company pays you a U.S. dollar dividend and you leave it in U.S. dollars. You don't get charged every time they deposit the dividend to your account. You only get charged if you put it back into CAD. So, if you're a long-term investor, we just say, create two accounts, one with Canadian dollars and one with U.S. dollars, and let it ride, because if you don't, you're going to miss out on tons of opportunity. TSX and TSX Venture stocks make up about 20% of the --

Hill: Toronto Stock Exchange.

Muckerman: Yep. They make up about 20% of the total stocks available to you in U.S. markets. So, not only are you missing out on diversification, but you're missing out on opportunity, in terms of breadth of choices. So, don't let the currency fluctuations scare you away from it. That's our opinion.

Hill: You've been to the Toronto Stock Exchange, haven't you?

Muckerman: Yeah, it's pretty cool. We went there a few years ago, poked around when we were first launching Stock Advisor Canada in 2013. Been up there a couple times since, but to not the same fanfare that we went up there a few years back.