How to F.I.R.E. outside the USA – a currency primer

When I was 17 I went to the US for a 1 month basketball tour with my Italian team; every two nights we were sleeping with a different family in a different town, but there was a ritual that happened at almost every stop: after the first dinner, the father would pick up the Atlas (yes, the physical one, back in the days there were no mobiles, no Google Maps) and ask me to point where ITALY was. Yes, not my hometown, the COUNTRY. Despite the technological advances since then, the average American remembers there is relevant life outside the US probably five minutes once per year, when the Academy Awards assign a prize to the best ‘foreign movie’.

The world of personal finance in the US (pun intended) is not that different. You invest in US based Indexes and, if you want to be brave, USD denominated assets comprising some international name (most likely in the bond space). Your benchmark is the S&P500. If you look at something outside the US, it is because you see it as an opportunity, not a necessity. Jokes aside, what I mean is that US-based investors are lucky, or at least have been so far, because they can build a well performing and diversified portfolio without having to look anywhere else other than home.

Life outside the US is different. Whatever your ideas and how rooted home-country bias it is in you, your portfolio most likely than not includes some USD assets. This means you have to manage an additional risk: currency.

The Accumulation Phase

A Vanguard seminar from 2015 states that currency hedging is not required for stocks, since the volatility of stocks exceeds that of currency, while bonds should be hedged, because the volatility of currency exceeds that of bonds. If we look at a survey done in Australia using real data from asset managers, the classic balanced portfolio is more likely to have about 28% of the equities and 61% of the fixed income currency-hedged.

The Vanguard ‘rule of thumb’ makes sense: if we exclude big currency events (Brexit, CHF de-peg from EUR) that should not happen frequently, the FX contribution to a stock portfolio is minor compared to the returns, or losses, produced by stocks themselves. The bond part is actually bit more complicated. If you want to rely on the predictability of bond cash flows (when you are in retirement, for example), then definitely you should hedge the FX risk, especially considering where interest rates are today. But if your horizon is longer, i.e. you are in the accumulation phase and therefore you do not care what happens to your portfolio in the next year, might make sense to not hedge. Contrary to the standard finance theory, currencies with high interest rates tend to appreciate in the long term: this is called the ‘carry effect’ and it is well documented in financial research. This is because high interest rates attracts financial investments: if you want to buy a Turkish bond that pays 15%, you first have to sell your currency and buy Turkish Lira and then with the liras buy the bond, therefore creating demand for liras and supply for your currency. The ‘cost’ of this strategy is that high interest rate currency usually experience high drawdowns (and therefore high volatility), so during the life of your investment sticking to your plan is harder. In our example the alternative is to invest in a bond in your local currency, so if you are in Europe, in a bond that pays 0% (to be generous); the difference between 15% and 0% represent your margin of error: even if at bond maturity TRY depreciated 8% against the EUR, you end up with a 7% gain…not bad. Obviously this does not happen all the time for all currencies, but if applied to a well diversified portfolio of bonds, over a long enough time frame, a positive outcome is more likely than not.

Currency hedging is not free but has two cost components. The first is the difference in yield between the two currencies; if we go back to the TRY vs EUR hedging example, an FX hedge to ‘transform’ a TRY bond into EUR will cost you 15%-0%=15%. Yes, you will go back basically to the same yield you have for a straight EUR bond, the only difference will be the credit spread between the two issuers. The second component is the spread you have to pay to the bank you are placing your hedge with.

Without going into too many details, hedging is like an insurance, and as any insurance it comes with a cost. So, if you are not planning to touch your savings for the next (say) ten years, you should not do any currency hedging. Volatility due to short term shocks will disappear and the long term return profile will emerge. Someone might correctly ask why you should have bonds in your portfolio in the first place, if you are in the accumulation phase. Bonds can lower your portfolio volatility and help you stick to your long term plan; it is better to have a 60/40 portfolio that let you sleep at night than an 100% equity pile that you will sell at the first bear market, even if that pile has a better projected long term return.

Another, unintended, consequence of not hedging is that USD tend to overperform during periods of financial panics. I say unintended because it is not a given, future might differ from the past, but this overperformance make sense because when investors are scared, they run for the safest asset, which in the last 100 years happen to be US Treasury Bonds. This heuristic might not work if you live in other ‘safe havens’ like Switzerland or Japan but hey…you already live in a great place, go somewhere else to complain. So for the non-US investor, holding USD assets will help to smooth their portfolio return profile, reducing drawdowns and melt-ups.

As many YouTubers probably already suggested you, currencies can potentially be also a return source. There are professional money managers that run programmes to dynamically adjust currency hedging ratios and ‘tilt’ to or from currency positions based on shorter-term views around whether any currency is over- or under-valued and how global macro-economic themes will impact the currency’s supply and demand. My suggestion is to forget about it and DEFINITELY do not pursue it by yourself. If someone is good at that, by now he/she is running an hedge fund that you will never get access to; they are for sure not selling courses on YT.

My Experience so far

I discovered this “FIRE thing” less than three years ago and anyway I have no hope to retire anytime soon. I can write a very long post where I detail each year and the reason I gave myself why I could not save more. Last year my wife got a very nice job…with a great salary and despite that we managed to save not more than 20% of our combined incomes. Let’s say the direction is good but the finish line is more ‘retire comfortably at an age when you can still ski’ then retire early. All of this to say that I always considered financial decision regarding retirement as the classic retirement.

I have worked in Switzerland and now in UK but I always thought I would retire spending EUR (meaning not necessarily in Italy, since I have a growing discomfort regarding the racism problem my home country has…actually what’s growing is not my discomfort but racism itself in Italy). Therefore I managed my savings eyeing EUR: when I first moved to Switzerland I did not convert my savings into CHF but I did the reverse, I would regularly move savings from CHF to EUR, largely because the CHF was pretty strong against EUR after the SNB decision to remove the soft peg. Here in London I am doing the same: for example I do not use any asset hedged back to GBP in my pension scheme. I moved some EUR to GBP when I bought my apartment because, historically speaking, the GBP was weak compared to EUR. If the exchange rate will ever go below 0.8 I will start moving some GBP savings back into EUR.

Apart from the above actions (that I do mainly because I am stuck in front of a Bloomberg screen all day for my job) I don’t perform any currency hedging. Roughly 60% of my equity is in USD assets, so for example last year I underperformed what I call the financial narrative because EUR appreciated 10% ag USD; this is an important psychological aspect, at least for me: since the vast majority of financial content I consume is US-based, is not easy to see your equity line flat when everyone seems to enjoy double digit gains. You need to constantly remind yourself that you are playing a different game.

On the other side, I do not track the value of my apartment in EUR. Despite being a relevant part of my NW, it is not an investment, I bought it because we need a place to live (and because renting in London is a pretty bad experience). Part of the decision to buy was influenced by the fact that GBP was quite cheap after the whole Brexit saga, cannot deny that, but I will not feel bad if I have a loss on the FX when we leave.

I had several expat friends that became obsessed with the exchange rate, particularly in Switzerland because the de-peg was such a big event.

If your job is buying Google ads for a cruise company, thinking of becoming a forex trader overnight is… probably not a great idea? My advice to them was to stay focused on their long term goals, instead of trying to catch the bottom or the top of the market. I also had colleagues that were working in Switzerland but living in France, salary in CHF and mortgage in EUR: this is a type of mismatch that I would have hedged (or did not take in the first place). It is a calculated risk because there is an economic reason why this ‘arbitrage’ is there, but it is such a big gamble…they got lucky (imagine if things went the other way around).

The Retirement Phase

Here is when things get tricky.

If I look at my pension advisor plan, I will invest 100% in equity until I am around 55 and then slowly shift my portfolio to bonds, so that by the the time I retire, around 67 years old, my savings will be 100% in bonds. This strategy, called “glidepath”, minimises the risk that pensioners will see their savings cut in half by a bear market happening near the day they stop working. The pensioner has to sell a part of his portfolio monthly to fund his retirement so volatility is the enemy: if he wants to receive a stable monthly amount, he has to sell double the number of shares after a 50% drop in the stock market. This is the reason why pensioners portfolio are invested in bonds, to minimise volatility risk and have a greater visibility of future cash flows. This strategy is built on two (and a half?) key hypothesises:

• the distance between retirement and death is not too long
• bonds real return is positive
• (the State pension will cover your basic needs, like food, shelter, healthcare)

Yes, as you can see once Europe moved away from Defined Benefit pension systems, the solution offered was a ‘pampered’ jump into the void: here is a parachute (your savings), let’s hope is going to work. All hypothesises are hardly met in the current environment:

• life expectancy is growing and understandably people wants to spend the years gained extending retirement, not increasing time in the office
• real government bond returns, what bondholders get net of inflation, are negative since at least ten years and Central Banks have no plan to change this, quite the opposite
• this is really dependant on the country you are going to retire but in general, prospects for State pension to at least match inflation are quite bleak

The portfolio of a ‘traditional’ millennial pensioner, i.e. someone that did not plan to retire early, will still be closer to a FIREer one than your parents retirement. It will be impossible to have zero volatility, the question will be more how to design your portfolio and much volatility you have to stomach to eliminate the risk to outlive your savings. This is why I think that, even if you do not plan to retire early, there is value in following the discussion on effective financial solutions for FIRE.

Currency exposure is just another element of volatility.

Early retirees have not been tested yet by a real bear market, March 2020 fall was fast and the recovery even faster: even if you wanted to do serious damage to your portfolio, the window to operate was pretty narrow; a multi-year slump would create a different set of scars and reactions. Plus, I sense that the few pioneers out there are not really retired but they moved from a job they hated to one they care. We are still in uncharted territory, the 4% rule has not been stress-tested by real life events.

I have read multiple papers that try to create the perfect formula to help you decide if you are better off renting or owing your home. Lot of them see the flexibility that renting offers as an opportunity; few of them mention that renting means you give up control of a very relevant part of your life to a third party, your landlord. If there is a currency mismatch between your income (i.e. you have a USD-based portfolio of assets) and your costs (your rent is in EUR), the EUR appreciating against the USD would be like your landlord raising your rent. While in a normal situation your landlord will ‘grind’ you out, raising rent few percentage points above inflation every year (obviously, in countries where this is legal), a currency shock can be quite sudden; there might a point where the currency mismatch will force you to move. Imagine doing a deep research on the place you want to spend the rest of you life and then have to relocate somewhere else, most likely worse; imagine how much of your daily routine, your social life, you habits are linked to the place where you live. Is it a risk are you willing to take? Unfortunately the only solution is either to own your retirement place or to build an additional safety layer onto your saving pots…yes, instead of thinking about a lean FIRE you should drift more and more toward a fatter one.

If you look at history, it is more likely that the USD will lose its status as world reserve currency than not; this does not mean you can reliably predict which currency (or what, a digital currency? a digital asset?) will prevail next. The shift might not be painful because the winner will be linked to the biggest economy out there, conversely where your assets will be invested as well (that’s how market cap indexing works).

Retiring in a Developing Country, somewhere where the cost of living is lower than in the developed world, might seem the solution for the currency mismatch issue but the reality is again more complex than that. If that country is going in the right direction, its currency will appreciate against the USD: you will lose some purchasing power but you should get better services (remember that at a certain point you will be old and the local doctor will be one of your closest friend). If something bad happens, the local currency will crater but your savings will be fine, leaving you the possibility even to move away if needed.

A (minor) positive aspect is that a strong currency usually leads to low inflation. In reality, mostly depends on your personal inflation basket: for example oil is priced in USD, so your travel/car costs might go down, but not if you move around only by bike; same thing for your energy bills, even if this effect will disappear soon-ish since most utilities are moving away from coal/gas into renewables. The more you consume things that the country you live in import, the more this relationship is true.

Conclusion

Currency risk is high in the short term because movements can be sudden and meaningful. As for stocks, it is a risk you cannot afford when you are retired, you need to model your asset allocation in a different way. I read about an interesting strategy a while ago (unfortunately cannot remember where): keep two years of expenses in cash. Then every month, if the stock market is above the inflation adjusted price of when you retired, you take your ‘retirement salary’ out of your stock portfolio, otherwise you take it from your cash balance. You refill your cash balance once the stock market is above the high-water mark described before. In this strategy, you mark-to-market your stock portfolio in your local currency. This way, you should be able to avoid selling stock when they are cheap, i.e. during a bear market (or a currency shock).

It is not a perfect strategy because bear markets can last more than two years and the cash-allocated part of your portfolio represent a quite big return drag, earning close to 0%, but overall it should perform better than a 100% allocation to bonds hedged back in your local currency.

I am still working and still saving but all the above it is a really interesting topic for me, mainly because I did not decide yet where I want to be…and I want to be prepared once I get there. Hopefully in ten years we will meet on a Greek island to discuss how many errors there were in my post.

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