Tuesday, March 1, 2011

Dollar's Reserve Currency Status and Your Investments

By Larry Swedroe

There’s a lot of talk about the dollar being replaced as the world’s reserve currency. Understandably, many investors are wondering what this would mean for the markets. Fortunately, we’ve seen this before, and everything turned out fine.

It seems like almost every day investors are bombarded with news that scares them. The current list is extensive:

  • The continued high rate of unemployment (and even worse, the extremely high rate of underemployment, with many workers so discouraged that they have left the labor force and are no longer counted as unemployed)
  • The continued weakness in housing prices
  • The crisis with our national debt and the inability of Congress to act to reduce the deficits by taking on the big problems of entitlements
  • Iran and/or North Korea saber rattling
  • The contagion of crises spreading across the Middle East

Among the reasons that many investors have been scared off of U.S. stocks is all the talk about the U.S. losing its status as the world’s reserve currency. On Wednesday, the Financial Times reported that China had sold billions of dollars in U.S. Treasury bills for the second month in a row. The article also reported that Russia had pared its Treasury holdings for the second month, down to $106 billion from $122 billion.

It seems like this is the latest in a long string of stories and reports about dethroning the U.S. dollar as the world’s main reserve currency. For example, in June 2010, the United Nations released a report calling for abandoning the U.S. dollar as the main global reserve currency, saying it has been unable to safeguard value. The report received support not only from Russia and China, but also from Nobel Prize-winning U.S. economist Joseph Stiglitz.

In November 2010, China and Russia announced they’ll renounce the U.S. dollar and resort to using their own currencies for bilateral trade. China also announced plans to boost cross-border yuan-denominated trade with other countries 10-fold to 20 percent of total trade to reduce reliance on a few reserve currencies.

Then this month, the International Monetary Fund issued a report on a possible replacement for the dollar as the world’s reserve currency, saying that Special Drawing Rights, or SDRs, could help stabilize the global financial system.

If you’re like most investors, you’re probably nervous about how all this talk of replacing the dollar as the world’s dominant reserve currency will affect your investments. And the forecasts of doom and gloom from various gurus contributes to the stress you may be feeling. Fortunately, we actually have historical evidence that suggest that the best thing is to stop worrying and just stick to your plan — which as readers of this blog and my books know is almost always the best advice.

I first discussed the dollar’s status as the world’s reserve currency nearly two years ago. I noted that prior to the dollar taking that role, the British pound was the world’s reserve currency, a status it lost shortly after World War II. Not only that, but Britain’s industrial capacity was devastated because of the war. Given these conditions, you’d think that U.K. stocks would have done poorly relative to U.S. stocks. And you’d be dead wrong.

We have data on the FTSE All-Share Index going back to February 1955. From February 1955 through December 2010, the FTSE All-Shares Index returned 10.9 percent, outperforming the S&P 500 Index, which returned 10.0 percent.

There’s almost always bad news sufficient to scare investors. And the last two years have certainly provided their share. However, despite all the bad news and the plethora of crises, equity markets around the globe have provided spectacular returns since the bottom was reached in early March 2009. Unfortunately, because of the prior bear market and all of the continuing problems, many investors missed all or most of the rally, as it wasn’t until late in 2010 that equity mutual funds began to experience net inflows.

The great tragedy is that investors persistently make the same mistakes, like selling after periods of bad performance (when expected returns are higher) and buying after periods of good performance (when expected returns are lower). Buying high and selling low isn’t exactly a prescription for investment success. The best way to avoid making that mistake is to have a well-developed plan and stick to it, ignoring the clarion cries from the gurus, who don’t know what they don’t know.

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