The effect of a weak dollar on your portfolio

Currency trends can affect the yields on your international stock funds. Here's how you can protect yourself.

Question: Does the low value of the U.S. dollar today compared to foreign currencies make investing in international stock funds less attractive than when the dollar is strong? —Larry Mulcahey, Bloomington, Illinois

Answer: The value of the dollar versus other currencies in and of itself doesn’t determine whether foreign stock funds are more or less attractive to U.S. investors like you.

What does matter, however, is whether the dollar rises or falls against currencies after you invest in a foreign stock fund. And there the relationship is clear, if somewhat counterintuitive.

If the dollar weakens after you’ve bought an international equity fund, the currency effect will act as a tailwind of sorts, boosting the foreign fund’s return. Conversely, if the dollar strengthens, the currency effect will work against you, lowering the return. (This assumes that the foreign stock fund you’ve bought doesn’t hedge against currency fluctuations. If it does, then the dollar’s movements will have little or no effect on your fund’s return.)

A quick example shows why this is the case.

Let’s say you invest $10,000 in an international stock fund that buys foreign company shares denominated in euros. Before the fund can invest your money, it’s got to convert your dollars to euros. Assuming the euro trades at $1.54 - which was the case recently - your ten grand would fetch 6,494 euros ($10,000 divided by $1.54).

If the value of the fund’s stocks rises 10%, you would have a gain of 649 euros, making your investment worth 7,143 euros. If the value of the euro remains the same, then translating your euros back to dollars would give you $11,000 (7,143 euros times $1.54), giving you the same 10% return in dollars that you got in euros.

But what if the euro rises in value to, say, $1.60 (which is the same as the dollar weakening)? Well, in that case your 7,143 euros would give you $11,429 (7,143 x $1.60), which translates to a 14% return in U.S. dollar terms compared to 10% in euros.

If, however, the euro falls in value (i.e., the dollar strengthens) to, say, $1.48, then your 7,143 euros would give you $10,572 (7,143 x $1.48), which means your 10% gain in euros would be whittled down to 5.7% in dollars.

I should note that this little scenario simplifies things in many ways. I’ve rounded the figures, limited the example to one currency, ignored currency exchange and transaction cost and I haven’t considered what effect economic trends beyond currency fluctuations might have on the relative values of U.S. vs. foreign shares.

But the basic idea is that if you buy a foreign stock fund and the dollar then weakens, you’ll get a boost to the return generated in foreign currency, while a strengthening dollar will lower your return.

The question is, how, if at all, should you factor this tailwind-headwind effect of currency fluctuations into your investing strategy?

Well, I suppose if you really knew that the dollar was going to drop further in value you could buy foreign stock funds or increase your existing position in them hoping to get a currency boost. Or if you thought the dollar was going to rebound, you could hold off buying foreign shares or trim your holdings. Or, for that matter, you could simply buy or sell foreign currencies.

But I think that’s a dicey game for individual investors. Sure, looking back it’s easy to see that the dollar has been on a multi-year slide against the euro and other currencies. But as the example above shows, it’s what happens from this point on that will determine whether currency trends improve or erode your return.

And that’s where things get murky. I don’t think anyone is predicting a big recovery in the dollar’s value anytime soon. But some observers of the international investing scene say that with the dollar’s value at or near historic lows and the Federal Reserve probably nearing the end of its rate-cutting phase, the dollar is likely close to a bottom and could even rebound a bit from here.

Others contend that underlying economic fundamentals - such as our hefty budget and trade deficits - argue for continued weakness.

My position? I don’t try to predict currency trends. Instead, I advocate allocating a portion of your stock portfolio to foreign funds for the long-term return and diversification benefit they can add to an all-USA portfolio, not as a currency play. Since foreign and domestic shares don’t always move in synch with each other, owning both can reduce the volatility of your portfolio without sacrificing long-term returns.

Reasonable people can disagree about how much of your portfolio you should devote to foreign shares as well as how you should get that exposure. I’ve suggested 10% to 30% as a guideline, and I think broadly diversified foreign stock funds and ETFs like the ones on our Money 70 list of recommended funds are the best way to go for most people, as opposed to buying funds that concentrate on specific countries or regions.

Whatever percentage you choose and whichever funds you buy, be sure to rebalance your portfolio once a year. This way, your foreign funds won’t become too large a piece of your holdings when foreign shares are booming (whether aided by favorable currency trends or not), or shrink below your target percentage when your U.S. holdings are churning out bigger gains.

So unless you believe you have unique insights into the currency markets and the economic trends driving foreign markets, I say it makes no sense to try to time your moves in and out of foreign stock funds to take advantage of currency swings. If you want to do so without such knowledge, that’s fine. But you’ll be speculating, not investing.