About the Currency Psychology of Investors

By Nicolai C. Striewe

Frankfurter Allgemeine Zeitung, Finanzen, Janaury 27th, 2021, Nr. 22, p. 25.

“Should I invest in America? But if I do I’ll be exposed to currency risk” What goes on in the minds of investors when they consider currency risk? Four typical thinking patterns behind investor behavior are discussed below:

Investor One: “I only invest in the euro area to avoid exchange rate fluctuations.”

Investor Two: “The dollar has fallen about 9 percent in the past 12 months, and that’s why I won’t invest in America now.”

Investor Three: “The dollar has fallen, that’s why it should rebound soon. Now is the right time to invest in America.”

Investor Four: “The dollar currency trend is not of any significance to me because I invest globally for the long term.”

Investor One is a “home bias investor”. Investor One’s argument is valid, because if you want to avoid exchange rate fluctuations in principle, it’s best to invest in the euro area. However, Investor One’s portfolio is less diversified and may therefore have an unbalanced risk/return ratio. This would lead to a chronic lack of diversification. In terms of type of investor, Investor One is rather cautious, risk-averse and distrustful of investments abroad. His portfolio has what is called a “home bias,” an over-allocation of domestic and familiar assets.

Investor Two is a “momentum investor”. He extrapolates past developments into the future, in other words, his actions follow an “extrapolation bias”. His decisions are based on the assumption that because the dollar has fallen in the past it will continue to fall in the future. This effect is called positive autocorrelation or a “momentum effect” in economics. Investor Two prefers to invest in assets where he anticipates an existing market trend – i.e. in rising currencies and investments – will continue in the future. In doing so, he is not fundamentally wrong: the market actually sees the future dollar-euro exchange rate being lower than today’s rate of 0.82. And based on expectations noted in the derivatives market the rate will be around 0.80 in three years. However, even such a devaluation of the dollar of almost one percentage point per year would be bearable if the associated investment is rewarding. In addition, exports and economic growth are usually boosted by a weak currency, which could partially compensate for an exchange rate loss.

Investor Three is an anti-cyclical or contrarian investor. He deduces from a falling dollar in the past a contrary, positive performance for the dollar for the future. This conclusion is based on the assumption that deviations from the long-term mean or trend are usually not fundamentally justified and should therefore reverse. Like Investor Two, Investor Three also assumes an autocorrelation of the price trend. In this case, however, it is a negative temporal correlation, i.e. not  “momentum” but a “mean reversion”. Investor Three invests countercyclically or contrary to the market. He often overestimates his own perception and the importance of the past for the future, but underestimates the efficiency of the markets.

In this consideration of the various investor classes, we will call Investor Four the “fox.” This is based on the wisdom of the Greek poet Archilochos, who in the 7th century BC said: “The fox knows many things, the hedgehog knows one great thing.” Archilochos thus considered people to belong to one of two categories: either fox or hedgehog. The hedgehog being a polarizing thinker, specialized, steadfast, stubborn, order-seeking and ideological. He is less able to be self-critical of his own knowledge and understanding and holds on to ideas unceasingly. The Fox, on the other hand, is a versatile thinker, multidisciplinary, self-critical, tolerant of complexity, and cautious. He is skeptical of overarching and all-encompassing concepts and the predictability of events.

Investor Four would thus be a classic Fox who doesn’t try to predict the future development of exchange rates. He does try to make his investment decisions less dependent on currency developments and trusts in the efficiency of the markets. He is more interested in the diversification effect of investments abroad. The Fox’s portfolio is broad, diversified across countries, asset classes and currencies. His strategy is more passive and less selective, but often more cost-efficient and with a balanced risk/return ratio.

What can be concluded from these different types of investors? Most small investors lack the rationality to make far-sighted decisions in capital markets. They often overestimate their own knowledge and judgment and underestimate the efficiency of the markets. Investor types one to three tend to be “hedgehogs” who pursue one-sided strategies. The fox type trusts in diversification and market efficiency. The literature shows this investor type four to be a better performer in investing because he takes advantage of geographic diversification and invests more cost-effectively. The influence of dollar-euro currency fluctuations may affect his portfolio, but this effect is often random and negligible in the long run.

The author works for the global real estate private equity firm Taurus Investment in Munich and is a lecturer in risk management at the EBS Universität für Wirtschaft und Recht in Oestrich-Winkel.

­FULL VERSION (German)