Are foreign currencies good retirement investments?

Q: What determines the strength of a currency relative to the U.S. dollar? It seems odd the dollar is worth over 100 Japanese yen but only about 20 Ethiopian birr, when obviously Japan has a much stronger economy than Ethiopia. Would trying to exploit these differences be a good form of retirement investment?

A: That's an interesting question which needs to be taken in two parts: First, to address some basics of how currencies work, and then to comment on their appropriateness for retirement investing.

What determines currency exchange rates?

At the time of this writing, one Ethiopian birr equaled about 5 Japanese yen. As you point out, on the surface this seems odd given that Japan's economy is much larger and stronger than Ethiopia's.

However, while currency movements relative to one another are determined by shifting economic conditions, the absolute value of exchange rates is somewhat arbitrary. Different countries set their currencies at denominations that seem convenient, based on what they can purchase and how their populations are used to dealing with money. Occasionally, those levels can be reset to adjust to changing times.

For example, there are more than 100 yen to the U.S. dollar. To think of this differently though, suppose we valued things purely in terms of cents not dollars. One yen would be fairly close to equaling one cent. The size of the units can change, without changing the underlying value the currencies.

Whatever the absolute exchange rate, that rate moves based on interest rates, political policies, economic growth, military threats, etc. This brings up the question of whether those changes create a good opportunity for retirement investing.

Are currencies good retirement investments?

In its purest form, currency trading would be a highly risky form of investing for retirement savings for three reasons:

1. Changes are based on very complex sets of economic conditions

This kind of analysis isn't for everybody. It's tough enough to analyze an individual company or industry. Trying to account for all the geopolitical and economic factors that drive currency movements requires highly sophisticated resources.

2. It can be a highly-leveraged form of trading

If you invest in currencies through vehicles like futures or options, you incur the possibility of large, permanent losses, as opposed to the normal up-and-down fluctuations associated with more mainstream retirement investments.

3. Returns are highly unpredictable

Since retirement planning is usually based around some sort of return assumptions, this unpredictability makes it more difficult to figure out how much you need to save and what your asset mix should be.

While foreign exchange investing may not be for the average investor, there is a strong case to be made for international diversification. Investing in the stock markets of other countries gives you some participation in the currencies of those countries, along with their underlying economic conditions.

For starters, see what international investing options your 401(k) retirement savings plan has. It may have broadly-diversified international funds, or even funds that let you choose specific country participation. Incorporating some international investments into a broader asset mix can give you a moderate amount of participation in foreign currencies and markets. This can happen without you having to wake up in the middle of the night to find out where the Japanese yen or the Ethiopian birr closed at the end of their trading days.

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