Monday, June 04, 2007

Protecting Your Portfolio From a Falling Dollar

The Dollar has been declining against some major currencies for some time. The reasons for this are many, and I certainly don't pretend to understand all of them, however the causes include the U.S. trade deficit; the federal budget deficit; and the expectation that the Fed will begin lowering interest rates soon vs. rising interest rates elsewhere in the world.

Since your income and spending are both in U.S. Dollars, should you care about a falling Dollar? Absolutely. For one thing, while you pay for your purchases in Dollars, much of what you buy is produced abroad and is imported to this country. With a falling Dollar, the price of those imports will increase and you will pay more at the store. For another, if you travel abroad like I recently did, you will immediately notice that things are more expensive since your Dollars buy less local currency. However, the thing that I am most vigilant about is the impact of a falling Dollar on our investment portfolio.

It is no secret that investors from around the world put their money into U.S. securities and assets. Stocks, bonds, and real estate all depend to some extent on foreign money. If the Dollar continues to fall, foreign investors will see their U.S. investments decline when denominated in their own currencies. If they no longer get the returns that they expect, these investors could flee the market, and in so doing cause asset prices to decline. On the flip side, companies that are publicly traded in the U.S. and that derive a substantial portion of their income abroad, are actually likely to benefit from a decline in the Dollar. Goods and services exported from the U.S. will appear to be cheaper to foreign buyers who will be paying for them in their own local currencies. Hence, U.S. exporters are likely to sell more and earn more, possibly causing their stock prices to appreciate.

So, what am I doing to protect us from a further decline in the value of the Dollar. In a word: nothing. I already did everything that I think needs to be done and I am sticking to my strategy. This strategy is a simple one: (i) diversify internationally; (ii) diversify locally. Currently, close to 25% of our portfolio is invested in highly diversified international index funds. I believe that a decline in the Dollar is a net positive for these assets. A highly diversified portfolio of U.S. companies is also some hedge against a falling Dollar, since many of those companies derive a substantial portion of their revenue from exports, and a falling Dollar will improve the fortunes of exporting companies.

I must admit that our bond portfolio is not internationally diversified, however, bonds only account for 12% of our portfolio so the impact of diversification is unlikely to be a be a dramatic one, especially in relatively stable assets as bonds.

Finally, if you are planning a sizable purchase in foreign currency, you may want to consider hedging yourself against exchange rate fluctuations by buying the currency in which your obligation is denominated. For example, if you are planning a big trip to Europe this summer, it might not be a bad idea to buy your Euros right now.

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