One of the most common questions I get is “what will happen to the Canadian dollar?” Canadians are particularly concerned with the exchange rate between Canadian and U.S. dollars. Many planned sunny vacations this past winter were canceled or shortened due to our low dollar. So, what will happen with future exchange rates?
Currency exchange rates are determined in the largest market in the world, called the foreign exchange market. Here large international banks exchange trillions of dollars worth of various currencies every day. The tiniest mispricings or inefficiencies could be exploited by savvy participants for billions of dollars per year.
Suppose a talking head on television predicts a rise in the Canadian dollar. Let’s dig into what this prediction means. To begin with, if everyone else agreed with the talking head, then they would seek to profit by buying Canadian dollars immediately. This would cause the dollar to rise immediately.
So, a huge number of banks and other speculators necessarily disagree with our talking head’s prediction. This should make you wonder why you should listen to a talking head if people betting trillions of dollars every day disagree with him. The current exchange rate strikes a balanced price among huge currency traders. It’s hard to see why we should trust the talking head more than people betting real money.
So much for the logical part of all this. Let’s get to the more emotional parts. The talking head looks important. He has a nice suit and tie and looks smart and confident. He’s probably very likeable too. Maybe he’s the kind of guy who could get you to go $100k above the price limit you planned for buying a house.
It’s very hard to look at a confident, likeable person and say “He’s full of it. He has no idea if what he’s saying is true or not. If he really knew anything, he’d be making billions himself in currency markets instead of talking on television.”
It’s also hard to ignore people who have been “right” in the past. The Canadian dollar only goes up or down (or rarely stays flat), so it’s very likely that a talking head could be right a few times by chance alone. If you make 20 predictions randomly, you’re likely to get 3 in a row right somewhere along the way.
Another thing that makes it hard to ignore the talking head is that we care about the future of the Canadian dollar. Knowing what will happen would bring important advantages. It’s hard to ignore someone who says he’s going to tell us what we need to know.
Yet another thing that keeps us tuned into the talking head is that we feel it must be possible to work hard enough to predict what will happen. Our hindsight bias makes us think that past movements in the dollar were predictable when they really weren’t at the time. With this hindsight bias, why wouldn’t we think that someone could predict where the Canadian dollar is going in the coming months?
We need to embrace the fact that we’ll never know whether the dollar will go up or down. The only practical plan is to conduct your life in a way that you’ll be okay no matter which way the dollar heads. For some people, this may mean making investments denominated in U.S. dollars.
When I’m asked what I think will happen to the dollar, I usually give some shortened version of these thoughts, and most of the time my arguments simply bounce off. A few people have accepted this logic, and fewer disagree. Most simply move on to the next person and ask “what do you think will happen to the dollar?”