Protect yourself from the dollar drop

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NEW YORK (Money) -- Question: I know I can protect my portfolio against inflation by investing in TIPs and against market volatility by diversifying my investments. But how can I hedge against adverse U.S. dollar movements? - Brian Canes, Scarsdale, N.Y.

Answer: It's not surprising that, like you, many investors are looking to insulate themselves from fallout from the declining buck or even profit from its slide.

After all, the dollar - which recently slumped to an all-time low of $1.48 vs. the Euro - has been commanding less respect lately than the late comedian Rodney Dangerfield used to get. There's been talk that central banks may begin diversifying at least part of their currency reserves into Euros, while some oil-rich Persian Gulf countries are considering no longer pegging their currencies to the dollar.

The dollar's even getting dissed in pop culture. Rapper Jay-Z's "Blue Magic" video shows him flashing 500-euro notes rather than "Benjamins," or $100 bills, the traditional status symbol of choice.

But as understandable as the urge may be to react to the dollar's woes, I caution you against dramatically overhauling your portfolio to guard against any single risk or capitalize on a specific trend.

Why? Well, what if the risk you're defending against doesn't turn out to be as dangerous as you think or the opportunity as big as it seems? What if, after several years of decline, the dollar bottoms out or even rebounds? You're better off structuring your portfolio so that it can thrive under a variety of future scenarios rather than making big bets on a specific theme.

All of which is to say that if you're going to invest to hedge against or profit from a falling dollar, you should be thinking about tweaking your portfolio at most - and even then doing so only after you're sure you've got a well-diversified group of stocks and funds that makes sense given your overall financial goals. (For more on how to create such a portfolio, I suggest you check out our Money 101 lesson on Asset Allocation.)

With that caveat in mind, I'll give you three ways you can play the wobbly dollar theme, the last of which is the one I think you should give the most consideration to. That done, I'll also refer you another way to cope with the ailing buck that appears in the December issue of Money Magazine.

This is the simplest strategy to take advantage of a sinking dollar, and it's easier to do today than ever before for individual investors.

For example, online banking firm Everbank offers deposit accounts ($2,500 minimum) and CDs ($10,000 or more minimum) in a broad range of foreign currencies, including the Australian dollar, the euro, the Norwegian Krone, the Japanese Yen, Chinese Yuan (aka, Yuan Renminbi) and the Singapore Sling, oops, I mean Singapore dollar. You can also bet on currency movements by investing in currency ETFs from Rydex (see correction at end of story).

To come out ahead doing this, you've got to buy a currency that appreciates as the dollar falls. So, for example, if you were to invest $10,000 in a Euro CD or ETF when the Euro's value is, say, $1.46, and you sold a year later after the Euro had risen to $1.60, you would be up roughly 10 percent. (I say roughly because you might earn a bit of a yield as well, although you would also have to deduct expenses ranging from currency-exchange fees to brokerage commissions in the case of ETFs and ETNs.)

That sounds straightforward enough, and it's certainly easy to see how well you would have done had you embarked on this strategy a year ago. But it's hardly a given that the dollar will continue to sink against the Euro in the future. Many economists believe the dollar may be nearing the end of its slide against the Euro, although many believe it has still farther to go against some Asian currencies (not necessarily the Yen, however).

My feeling is that unless you really understand the interplay of economics, politics and currency trading that drives global currency values - and, frankly, I don't think many people really do - this strategy amounts to little more than putting your money on black or red at the roulette wheel. If the dollar doesn't drop against whichever currency you choose - or if starts climbing versus that currency - you could end up with no gain or even a loss.

Again, the premise is pretty simple. The price of gold generally tends to move in the opposite direction of the dollar for several reasons. One is that a falling dollar may lead to inflation in the U.S. due to rising import prices, and gold is a traditional inflation hedge. Another reason is that anxious investors often hold the dollar because they seek safety in uncertain times.

When the greenback shows signs of weakness, however, many of these jittery investors move on to gold. And, in fact, as the dollar has dropped to new lows, gold has risen to new highs, nearly hitting $850 an ounce two weeks ago, a level it hasn't seen since January, 1980.

But despite gold's reputation as a safe haven, it's actually one of the most volatile investments around. Indeed, in recent days, the price of gold has fallen back below $800. Given its flightiness, I don't think gold is a good choice for most people. It's the kind of investment individuals are more likely to buy after it's had a big run, which is precisely when it's most vulnerable to a big fall - or a long period of stagnation.

I suppose you can make a case (although I'm not a big fan of it) for keeping, say, 5 percent to 10 percent of your portfolio in gold because it doesn't move in sync with stock prices. But to get that diversification benefit, you've got to be willing to sell when gold prices are high and buy when they're low, which is emotionally difficult for most people to do (although a simple process of annual rebalancing achieves this goal).

And even if you think you can follow that approach, I think you're likely better off in a precious metal mutual fund than owning actual gold.

Putting a portion of your money into one or more stock mutual funds that invest in a variety of countries outside the U.S. is a weak-dollar strategy I can recommend for several reasons. For one, when the dollar falls, your return from foreign stocks gets an extra boost from the currency effect.

How? Let's take a look at a simple example. Say you had invested $10,000 in European stocks at a time the Euro was trading at $1.30. To invest your money, you would have had to convert your $10,000 into Euros. (The fund would do this for you, of course, if you invest through a fund.) If Euros had been trading at $1.30 at the time of your investment, you would have received 7,692.3 Euros ($10,000 divided by $1.30) to put into stocks.

If those stocks had then gained 10% over the course of a year, they would be worth 8,461.5 Euros (your original 7,692.3, plus another 769.2 from the 10 percent gain). If the exchange rate didn't budge during the year, you would receive $11,000 (8,461.5 Euros times $1.30 per Euro), giving you a 10 percent gain on your original $10,000. (For simplicity's sake, I'm ignoring currency-exchange fees and other costs.)

But what if the Euro had risen to $1.46 by the time you sold? In that case, you would have received $1.46 for each of your 8,461.5 Euros, giving you $12,354, or a 23.5 percent return on your original ten grand.

In short, the currency effect of a rising Euro vs. the dollar magnifies the underlying return on the stocks.

Of course, the currency effect would work against you if the dollar rises against the Euro. But what I like about this approach as opposed to just buying the currency itself is that you also stand to profit from any gains on the stocks themselves. Assuming you're in for the long term, such gains, though hardly guaranteed, are pretty likely.

Another advantage to this approach is that adding foreign exposure to your equity holdings means you're not dependent solely on the fortunes of the U.S. market. And since U.S. and foreign shares don't always zig and zag in unison, holding foreign stocks can actually reduce the overall volatility of your portfolio while enhancing returns. (For more on the diversification benefit of foreign shares and how to achieve it, click here.)

Of course, foreign stocks have experienced quite a boom the past few years, which means they're not exactly cheap. So if you're getting into foreign stock funds for the first time or want to add appreciably to a small position, you'll probably want to do so gradually over the course of a year or so. For the names of solid foreign-stock funds that can give you this international exposure, you can check out our Money 70

Finally, in a story titled"What the Sinking Dollar Means For You", my Money Magazine colleague Paul Lim outlines a few additional steps you might consider taking to hedge against a falling dollar. Paul's story is also worth a read because it discusses some risks the sliding buck may have for the U.S. stock market.

Bottom line: You're going to have to navigate a variety of risks now and in the years ahead. And if you try to revamp your portfolio too much to protect yourself against a falling dollar or any other single threat, you could end up leaving yourself even more vulnerable to other perils.

Due to an editing error, an earlier version of this story incorrectly said that currency ETFs from Rydex are sold by Barclays, the creator of iShares ETFs.