Serious Money: Sticking to euro-based rather than diversified investment portfolio will protect investors from vagaries of global exchange rates.

One of the more remarkable aspects of the foreign exchange market in recent years has been the relative stability of sterling against the euro.

Now, markets are designed precisely with the aim of humiliating the authors of such statements. History is littered with examples of careers ruined by an immediate rebuttal of such sweeping generalisations. An eminent finance academic, Irving Fisher, is remembered as much for his famous prognostication on the eve of the 1929 stock market crash as he is for his learned intellectual achievements. He reckoned that stocks had reached a sustainable plateau. The rest, of course, is history.

Exchange rates are the most capricious of financial markets, much more so than equities. But the money to be made from a correct exchange rate forecast can often dwarf the opportunities arising from other asset classes. A$2 trillion dollar (€1.7 trillion) a day global market offers plenty of liquidity and loads of opportunities to make or lose money.

It's not just short-term traders who are interested in exchange rates. These days, any investor in almost any equity market is making an exchange rate bet. Clearly, any purchase of stocks or bonds outside the euro zone requires careful thought about exchange rate risk. But the reality is that investments in many domestic (defined nowadays as the whole euro zone) equities involve some measure of exchange rate risk.

Europe's equity markets are dominated by large global companies, many of whom are not European at all. They just happen to have their headquarters here; their history may well be rooted in Europe, but one of the least remarked aspects of globalisation is the extent to which many well-known companies have transcended their local origins. In many cases, this is because they had to adapt to survive.

Global competition means that many of our companies are competing with companies from around the world and are held to account by shareholders operating on a different standard compared to docile domestic investors. "Adapt or die" could be the motto for many European businesses.

The process of globalisation means that the vagaries of the foreign exchanges now have a bigger impact than ever on the performance of European business. It's not just about the obvious effects on imports and exports; movements in exchange rates can have weird and wonderful consequences, not least through the ways in which competition can appear from nowhere, almost overnight, thanks to relatively small movements in currencies.

Many businesses now own assets all over the world. The impact on balance sheets, not just the profit and loss account, can be very significant.

One simple example: oil companies are truly global businesses. British Petroleum (BP, to give it its correct name) is no longer a particularly British company, for fairly obvious reasons. If Gordon Brown wanted to tax BP's "windfall profits" from high oil prices, he would be hard pressed to get his hands on the company's cash. Most of it is now outside his jurisdiction. Clearly, BP is affected by the oil price in all sorts of ways, but that is a commodity denominated in dollars. So the company - and its investors - have to worry about two of the toughest financial variables of all to forecast: the oil price and the dollar. Good luck.

Ryanair is another example of a company whose hedging policies attract huge amounts of market attention. Mostly, analysts concern themselves with the extent to which the airline has hedged itself against future increases in fuel costs but, either implicitly or explicitly, there is an exchange rate forecast that matters, given the dollar pricing of oil.

Companies and investors have to be aware of the currency risks they run and the extent to which they should try and hedge those risks. For the individual punter, this is no mean task. In principle, some assessment of all the underlying currency risks in any portfolio should be undertaken and the resulting answer compared to the investor's belief or forecast of where exchange rates are heading.

The first problem with this is that it is next to impossible to gauge accurately the total amount of exchange rate risk. We would have to know all about the various direct and indirect channels whereby our portfolio could be affected by currency fluctuations. Imagine how long it would take to work that out for an equity portfolio that contained lots of companies like Ryanair and BP (or one that just held those two stocks).

So much for statements of principle and warnings about how hard all of this is. Is there anything practical that we can do? Well, without the ability to make an accurate exchange rate forecast, the answer is no. So, even if we can work out what currency risks are being run in our portfolio, that won't be much help unless we are good currency forecasters.

Given how globally diversified - and therefore naturally hedged - many companies are, it is tempting to conclude that a well-diversified portfolio actually does not contain many net currency risks. If we hold a lot of US and British companies it might feel, as euro-based investors, that we are running lots of currency risk. But, counter intuitively perhaps, that is not necessarily the case. Even if we could make accurate bets on exchange rate movements, it might turn out that we are adding, rather than subtracting from currency risk. In other words, we would become currency speculators rather than portfolio investors.

The trouble is, we can never be sure. Few of us can forecast currencies, so the best recommendation to anyone worried about this sort of thing is to stick to euro-based investments. Otherwise, hold a well-diversified portfolio.

Anyone who needs to hedge should think about the exchange rate that would make them comfortable: if they see a forward exchange rate that they can live with, they should do so, notwithstanding currency forecasts to the contrary. And that view on sterling? It's been remarkably stable for a long time. My totally hedged view is that this will continue for the foreseeable future.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.