Risk #3: a dollar collapse
In March it cost $1.58 to buy a single euro. In 2002 all it took was 87¢. If you've taken a trip to Europe lately, you know exactly what a weak dollar means for your travel budget. But how else does the ailing buck affect your life?
For starters, you'll pay more for imported goods from most other countries. Fuel costs will also go up because oil is priced in dollars and foreign buyers are bidding it up with their stronger currencies. True, a weak dollar does goose exports by making U.S. products cheaper. But overall it hurts economic growth at home, which in turn jeopardizes your financial well-being.
The wrong way to hedge the dollar is to trade currencies or buy individual foreign bonds. For an individual investor, guessing which way currencies will move in the short run or which country's money will outperform ours is as difficult (and senseless) as trying to amass retirement money at the roulette table.
Instead, the best way to hedge against a possible further decline in the dollar is to buy diversified mutual funds that invest overseas.
Full disclosure: These funds have soared over the past five years, and it's hard to imagine that they can continue to outperform in perpetuity.
Yet the fact of the matter is, most individual investors still have too little of their money in overseas equities. The non-dollar-denominated stocks and bonds that these funds hold will give you wide exposure to currencies and economies that may be on a stronger track than ours.
If so, you'll stand to make money both on the currency exchange and on the strength in the underlying investment. Conversely, if the dollar strengthens against the currencies represented in your fund's portfolio, you could take a loss even if the underlying stocks hold up fine.
How much money to put into overseas securities? Experts say a reasonable approach is to keep at least 20% of your stockholdings in a broad-based foreign-equity mutual fund and 20% of your bondholdings in an international bond portfolio. (If you don't have at least that much in such funds already, put the money in gradually over several months so you don't wind up investing it all on a bad day.)
That 20% will give you enough international exposure to help counter the dollar's weakness, but it won't be so great that you or your portfolio will be devastated if the performance pendulum swings back to the dollar and U.S. stocks.
For the equity fund, consider the low-cost Vanguard Total International Stock Index (VGTSX), which has returned 6.7% annually over the past decade. For the bond fund, T. Rowe Price International Bond (RPIBX) is a good choice in part because it usually doesn't use currency maneuvers to hedge exchange-rate gains and losses as some other bond funds do. You need those exchange-rate fluctuations when your goal is to hedge the dollar.