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, sold by Barclays, the creator of iShares ETFs.
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.