Hawes: Spreading your investment risks
Two weeks ago, this column warned against the common practice within the finance industry of hedging international investments back to New Zealand dollars.
The article created some comment in other media and amongst financial advisers. Most of the comments that I saw were intelligent and thoughtful, but there was some that made me think that there are many people who are not sure why they should have a good part of their investments offshore. And so, I thought I should take some time and space to explain the rationale for investing overseas.
All investment starts by first looking at the investor's liabilities. That may sound counterintuitive: After all, investors are considering what they will do with their assets, not their liabilities.
However, before deciding what assets (investments) you will own, you need to know what you are liable for - what risks you face and what you are going to do with your money eventually.
When you know what you are liable for, you can then try to match that liability with an appropriate asset. Effectively, a liability with a matching asset squares off the position and takes the risk out of your liability.
For example, the chances are you are liable to require a roof over your head for the rest of your life. If you match that liability with the ownership of a house, you no longer have the risk of a major rise in the cost of buying or renting a house. You have matched the liability of a roof over your head with an appropriate asset and so no longer have the risk of unaffordable housing.
Another example: If you were planning to take a major European holiday next year, you would know the approximate cost of the trip (let's say, € 12,000). To eliminate the risk that there could be a major fall in the New Zealand dollar making the trip prohibitively expensive, the wise thing to do would be to purchase € 12,000 as soon as you can. That would mean you have matched your liability for the cost of the trip with an appropriate asset (savings of € 12,000).
There are many other examples of matching liabilities with appropriate assets. In fact, a good deal of the financial planning process is about looking at a family's concerns and risks, and trying to mitigate risk with an asset: A family liable for the children's education costs should have savings that will cover those costs; a family concerned about health issues should also develop a fund for that (or pay for insurance).
In fact, we often do these things intuitively without using corporate-style language like "matching assets with liabilities" - we just get on and save amounts for where we have concerns.
So, what does all this have to do with investing offshore? Actually, a great deal.
As Kiwis, we are liable to purchase goods that have been imported: Cars, petrol, clothes, electronic goods - even a lot of our food items are now imported, or the price is set internationally. In fact, it is likely that the imported component of our expenditure is around 40 per cent.
We know that if the currency declines sharply, all of the imported things that we buy will become very expensive. We can match this liability to purchase imported goods by buying an appropriate asset in the form of offshore investments. Owning offshore investments means that investors have cancelled out the risk of major fall in the value of the New Zealand dollar.
Those who have offshore investments will still have these higher costs, but the value of their offshore investments will have increased. Their increased costs and continuing liability to buy imported items, are offset by a matching of their offshore investments.
If 40 per cent of expenditure is on imported goods, that should be matched with 40 per cent of our investments going offshore.
Two weeks ago I wrote of the risk of some New Zealand calamity (another earthquake, biosecurity breach and so on), but it may not be as dramatic as that - the New Zealand currency could fall against our trading partners gradually over a few years.
Matching an asset with the liability to buy imported goods is not the only reason to own offshore investments: The ability to access a whole lot of industries and investment opportunities not available locally is also important.
Nevertheless, matching an asset with a liability to purchase imported goods is the most important factor and the reason I do not think such investment should be hedged back to the Kiwi dollar.
Martin Hawes is an authorised financial adviser and a disclosure statement is available on request and free of charge, or can be found at martinhawes.com. This article is of a general nature and is not personalised financial advice.
Sunday Star Times