Investment Insider: Get ready for world currency games

Exchange rates make investing abroad a risky business

One of the easiest ways for a company to boost sales is to cut the price of its goods and services.

Countries can do something similar to boost economic activity. They can devalue their currencies, which is a proxy for cutting prices. By doing this, a country is effectively providing its companies with an immediate leg-up. It has helped exporters become instantly more competitive, even if they have merely carried on as normal.

There are signs that many countries, if not devaluing, are intent on holding down the value of their currencies. For instance, the US is continuing to pursue quantitative easing, even though its economy is showing obvious signs of growth and employment is rising at a healthy clip.

Meanwhile, the European Central Bank has cut the cost of borrowing and New Zealand has held interest rates, even though there are indications its housing market may be overheating. Elsewhere, Japan is driving down its currency to help revive its economy through boosting exports.

Currency devaluation might, at first sight, seem like a clever ruse. But it can create unwanted problems for investors, especially those who buy overseas shares.

For instance, an investor might be delighted an investment in a company abroad has risen by 20 per cent. But the euphoria could quickly turn to disappointment should currency movements go 20 per cent in the opposite direction. In other words, the adverse movement could wipe out any capital gains.

Conversely, a poor investment might even turn into a profitable one should currencies move in your favour. So, even if shares might have done poorly, a favourable rate could turn a bad buy into an acceptable one.

Interestingly, though, it is not easy to sidestep currency risk. This may manifest itself even if you do not invest in overseas shares directly. About three-quarters of revenues generated by FTSE 100 companies comes from outside the UK. What is more, half of Britain's 100 largest companies generate negligible profits within the UK.

With two variables – currency and company performance – to ponder, investing in overseas companies or companies that generate income abroad might seem as difficult as trying to catch a fly with a pair of chopsticks.

It might be possible to insure against exchange-rate movements through currency hedging, but that merely adds extra costs to investing. In any case, countries that can adjust currencies downwards can just as easily massage them back up again.

One of the best ways to hedge against currency risk is to build a diversified portfolio of shares that have wide geographic interests. A good place to start may be through a low-cost, FTSE 100 index tracker. That way, you could get exposure to shares such as British American Tobacco, which generates almost 80 per cent of revenues outside the UK.

But the key question should always be: is it better to invest in a business with overseas links that exhibits strong fundamentals but with a risk the currency might fall, or invest in a business with poor fundamentals but a chance the currency might rise?

For me, it is always better to try to control something I can than something I can't. So, focus on companies, not currencies.