Over the years, there's been speculation about whether the U.S. dollar is losing some of its global dominance. The chatter became louder after Brazil's President Luiz Inácio Lula da Silva said, "Every night I ask myself why all countries have to base their trade on the dollar," in a speech during an April visit to China.
Is talk of the dollar losing its dominance overblown? In my opinion, without a doubt, it is. But let's dive deeper and unpack what investors should take from the chatter.
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The role of the U.S. dollar in the global finance system
The U.S. dollar has been the world's reserve currency since the end of World War II. Many countries around the world hold their foreign exchange reserves in dollars. Foreign exchange reserves are like a country's savings account, just in another currency.
Close to 60% of the world's foreign exchange reserves are held in dollars, which is generally preferred because of its stability and liquidity.
The dollar is also the main currency used in international trade for things such as oil, gold, and agricultural products. These things combined have put the U.S. in a position to influence a lot of global economics. It also allows the U.S. to borrow money at much lower rates than most countries.
How currency changes affect investors
The value of dollar in the global market affects investors in a few ways. Directly, it can affect investors' returns on investments in overseas markets.
For example, imagine $1 can be exchanged for 0.90 euro. If you invested $1,000 into a European company, you would have 900 euros. If the dollar weakens (the euro strengthens) and the exchange rate changes to $1 for 0.85 euro, you would get more dollars for your euros when you convert them back. In this case, your 900-euro investment would now be worth about $1,059 upon conversion.
Conversely, if the dollar strengthens and the exchange rate becomes $1 to 0.95 euro, your 900 euros would convert back to approximately $947.
Currency exchange rates fluctuate constantly, so this isn't just something to consider regarding current talks about the dollar; it's something investors should keep in mind when making international investments.
Investing outside of the U.S. is important
I strongly believe the threats to the dollar's dominance are exaggerated. However, recent chatter on the topic reaffirms the need for investors to look at diversification in terms of both industries and geography.
International markets are generally divided into two categories: developed and emerging. Developed markets are characterized by advanced economies, solid infrastructure, and well-established industries. Examples include South Korea, Canada, and Japan. Emerging markets don't currently have the stable economies, markets, or infrastructure of developed markets, but they're seen as progressing toward it. Examples include Mexico, South Africa, and China.
By investing across in both types of markets, investors can benefit from the relative stability associated with developed markets while tapping into the growth opportunity emerging markets present.
One good option is a broad exchange-traded fund such as the Vanguard Total International Stock ETF (VXUS 0.76%), which contains more than 7,900 companies from both developed and emerging markets. The breakdown by region is as follows:
- Emerging markets: 24.5%
- Europe: 41.7%
- Pacific: 26.2%
- Middle East: 0.4%
- North America: 7.2%
Investing in individual international companies can sometimes be more complex because you have to consider factors such as the local economy and politics, but a broad ETF such as the Vanguard Total gives you exposure to companies around the world in a single investment.
Great companies exist worldwide, and only focusing on those in the U.S. would be doing yourself a disservice. It also helps you hedge against the U.S. economy in a sense. A rule of thumb I like to follow is to have about 20% of your stock portfolio in international stocks.
