Bryan Caplan  

If You'd Listened to Me, You'd Be Happy About the Falling Dollar

The Iceberg Groweth... Freddie Mac--victim, villain, ...

Two years ago I denounced home country bias, people's propensity to invest solely in their own country's assets. International diversification is a free lunch in terms of mean-variance efficiency, but most of us pass on it. As Karen Lewis explains:

Indeed, a portfolio of 100% share in the S&P 500 is dominated by all portfolios with foreign share of about 39% corresponding to the minimum variance point B. Nevertheless, estimates from the literature put the share of US holdings of foreign equities at about 8%...

An added benefit which I didn't mention is that international diversification protect you against exchange rate fluctations. Yes, if you'd listened to me, the falling dollar wouldn't be nearly as worrisome. In fact, if you'd taken Karen Lewis' results to heart, at least 39% of your assets would be held in foreign assets - and a falling dollar would be something to celebrate.

Just don't do it publicly - or people might accuse you of being un-American!

COMMENTS (12 to date)
Geoffrey writes:

Thanks Bryan..

Former Student of yours....

80 percent of my 401 K in Foreign assets

sean writes:

And now what shall I do timing guru?

Lord writes:

Certainly haven't seen China want a strong currency. Then again, their foreign investments here aren't going to do too well.

N. writes:

...not only that, but those folks who complain about international job outsourcing should be happy! With a falling dollar, more countries will be likely to spend on *koff* *koff* cheap American labor!

8 writes:

You didn't look so smart from 1995-2000.

A not insignificant amount of the difference between U.S. and other developed equity markets is currency fluctuations and economic cycles. I never understood the point of owning falling assets in order to be "diversified".

eccdogg writes:

Well isn't the point that you don't know what is going to be rising or falling before hand so you should own a little of everything. Note Bryan didn't say 100% he said 49%.

Of course if you know what is going to rise and fall before hand of course you should not diverify. Just put all your money in what is going to rise and enjoy the rest of your days from your yacht in the islands.

Gary Rogers writes:

A few things to think about:

A strong currency favors consumers while a weak currency favors producers. More important, though, is what happens when currency is in a state of flux. A falling currency favors borrowers while a strengthening currency favors lenders. As long as a currency is stable whether weak or strong, borrowing and lending continue without incident. From a static viewpoint, I think I would favor a weaker dollar to put things back in balance. But on the dynamic side, I am extremely worried.

You might think that it would be to our advantage to have a falling dollar, given our trillions of dollars in debt. We just pay back the loans in cheaper currency. But, when you consider the other side of the transaction the lenders experience the disadvantage of owning a falling currency and insist on higher interest rates. This means credit dries up or the cost of servicing the debt climbs. Neither is a good option. We need to be careful about how we manage the change.

The biggest danger is that the dollar continues to weaken over a period of time and the interest rates on dollar denominated accounts are not sufficient to make up cost of owning a devaluing asset. Those holding dollars begin to convert them to other currencies causing the value of the dollar to fall even faster. In engineering terms this is a feedback loop where the output feeds back through the system iinput, amplifying the signal. In economic terms, this is a classic currency collapse and the interest rates required to reverse a collapsing currency are severe and damaging.

In short, a weak dollar is OK but we need to be careful how we get there.

8 writes:

Yes, passive investors should diversify.

But if 39% of my assets are in foreign assets, 61% is still in dollars, so the falling dollar still hurts me. It would hurt me less, but it would still hurt.

Also, currency fluctuations are part of my return. If I am American, I am not hurt by a falling dollar as much as I would be hurt if I was fully invested in European stocks and the Euro fell. Foreign currency fluctuations directly impact foreign stock holdings, but currency fluctuations do not necessarily impact domestic stock holdings.

Barkley Rosser writes:


The dollar goes down, and the dollar goes up. That is the whole point. You want to be diversified. The 39% allocation was historically a minimum variance allocation, that is a minimum risk allocation, not a maximum return allocation. The joke is that anyone with a lower allocation tha 39% is getting both more risk and lower return (on average), although one of the reasons for home equity bias is precisely that most people do not notice that they are losing money in opportunity cost terms when their own currency assets go down, especially when most others they know are experiencing the same loss.

As for me, well, I have long been advising anybody who asked me to go 50-50, which about approximates the risk of a 20% dollar holding, but beats the hell out of it on expected return, including that of the 39% allocation.

BTW, until pretty recently, although I know this is now changing upwards, the average allocation in the US was 8% of assets held outside the dollar. Many investment advisers knew this was silly, but were afraid of being caught on the downside of a dollar upswing and being criticized. This is the old argument from Keynes about it being OK to be a loser in a herd, while losing alone much more than offsets winning alone. So, investment advisers give this bad advice in a herd (also perhaps afraid of this "unAmerican" charge, although people in other countries also suffer from the same bias to varying degrees).

8 writes:

If you read Triumph of the Optimists, there are only a few developed markets that beat the United States in terms of performance in the second half of the 20th Century, and some were small markets like Sweden. There really wasn't a strong argument for diversifying overseas, except for Japan.

I don't think people we're being chauvanistic, they were looking at returns and seeing there wasn't much to be gained. If you plot the S&P 500 Index versus the EAFE ex-Japan, it basically tracks the S&P 500. In local currency, since inception, foreign stocks (EAFE ex-Japan) are still underperforming the S&P 500 today. The current outperformance is entirely dollar related. And the "free" gains in terms of portfolio volatility that existed before may be gone.

Going forward, the argument for foreign stocks is China (maybe India), just like it was Japan before. If you think foreign stocks will outperform, buy China (probably not a good idea at the moment) because that's the only way it's going to happen. And it's not in the EAFE right now, so you have to look for it to get it.

Barkley Rosser writes:


Still irrelevant as it ignores the relative ups and downs. If one is sufficiently diversified, one can catch the gains on the other markets when the dollar ones are doing badly, and vice versa, thereby coming out ahead of a purely dollar-denominated portfolio. That is what the study cited by Bryan Caplan done by Karen Lewis showed. At a 61% dollar allocation, one did way better in terms of both return and risk than at a 100% dollar allocation.

General Specific writes:

And if people would have taken my advice to invest in oil because of peak oil, their portfolio would also be happy. By the way, I moved a lot of assets to European stocks years ago. Worked out great. Those socialists are doing well by my portfolio.

Comments for this entry have been closed
Return to top