The Effect of Currency Diversification — Spreading Eggs Across Currencies
The 'diversification' of spreading assets across multiple securities is familiar, right? But have you ever thought about the fact that 'currencies' can also be spread? Holding 100% won is in fact also a state of going all-in on a single currency.
Currency is also an object of diversification
We are usually familiar with diversification that divides 'asset types' like stocks, bonds, and real estate. But which 'currency' an asset is denominated in is also an important axis of diversification.
If someone living in Korea holds only won deposits and won assets, they have effectively bet their entire assets on the single currency of the 'won.' If the won's value falls sharply (the rate spikes), the purchasing power they feel abroad shrinks along with it.
Currency diversification is a strategy of holding assets across multiple currencies to reduce the shock when one particular currency swings sharply. For example, holding won assets and dollar assets together allows one currency to act as a buffer when the other weakens.
In particular, since the won tends to weaken in a crisis, there is room to consider whether mixing in some safe-haven-currency (dollar, etc.) assets helps with crisis defense.
Why it works — the power of correlation
The reason currency diversification reduces risk lies in 'correlation.' It is the principle that mixing assets that move in different directions reduces overall volatility.
For example, suppose a Korean investor holds U.S. stocks (dollar assets) without currency hedging. When a crisis comes in which U.S. stocks crash, as in 2008, the won also tends to weaken (dollar strength) at the same time.
Then the exchange-rate gain from dollar strength offsets, to some degree, the loss seen in U.S. stocks. Even if you lose big in dollar terms, in won terms the loss is smaller. This is a representative example of currency diversification acting as a buffer in a crisis.
Conversely, if the won strengthens in a calm period, this exchange-rate gain can disappear or turn into a loss. Currency diversification has a nature that shows its power especially in 'crisis defense.'
The limits and costs of currency diversification
Currency diversification is not a cure-all. You must also view several limits and costs together.
First, the correlation between currencies is not fixed. Currencies that normally move oppositely can move together in certain periods, weakening the diversification effect.
Second, handling multiple currencies increases exchange and transaction costs. The exchange spread is a hidden cost that is not easily noticed.
Third, currency diversification is not a 'strategy to increase returns' but a 'strategy to smooth risk.' If it becomes a bet to guess that a particular currency will strengthen, it deviates from the very purpose of diversification.
Ultimately, the key is not to predict 'which currency will rise' but to reduce the risk of a state entirely bet on one currency. That this site shows the exchange-rate effect separately is also to help you confirm with data what impact currency diversification actually has.
This article explains the concept and limits of currency diversification and does not recommend buying any particular currency or asset, or predict future exchange rates.
よくある質問
Q. Is it risky to hold only won?
Rather than 'risky,' it is more accurate to see it as 'a state concentrated in one currency.' If you live and spend in won in Korea, a won-centered position is natural in some ways. However, if you have a lot of overseas assets, overseas travel, or imported-goods consumption, or want to reduce the shock of won weakness in a crisis, you can consider diversifying some into other-currency assets. The right answer varies by individual situation.
Q. How do you go about currency diversification?
The most common method is to hold overseas assets (e.g., U.S. stocks and bonds) without currency hedging. That naturally exposes you to that country's currency. Besides this, foreign-currency deposits are also a method. However, you must weigh exchange costs, taxes, and each currency's characteristics together, and this article does not recommend any particular method or currency.
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