Protect Yourself From the Dollar's Decline

It wasn't that long ago that many saw the U.S. dollar as the safest currency in the world. Now, though, a combination of factors has raised questions about whether the global financial system would be better off with an alternative to the dollar as the world's dominant reserve currency. Regardless of whether foreign governments and policy-making bodies succeed in establishing a new reserve currency system, you can take steps to shore up your own portfolio against the potential havoc a falling dollar could wreak.

The arguments against the dollar
The latest salvo in the debate about whether the dollar should be replaced by a new reserve currency came from the International Monetary Fund this week. Yesterday, an IMF report argued that a specialized financial instrument it uses called Special Drawing Rights could help stabilize the currency system. Essentially, SDRs give their holders the ability to accept repayment in whatever currency they choose, with exchange rates determined by a fixed basket of international currencies. In addition, the IMF said that it could create government bonds denominated in SDRs as a potential replacement for U.S. Treasury bonds, which many central banks have to own in order to meet their own reserve requirements.

Yet other countries have already taken their own steps toward reducing dependence on the U.S. dollar. Late last year, Russia and China agreed to make it easier to use each other's currencies for international trade between the two countries, rather than pricing transactions in U.S. dollars and incurring the hassle and expense of multiple currency conversions back and forth. The two countries, as well as India and Brazil, have been having discussions for a while now about substituting other methods of exchange in place of dollars.

It's not hard to understand why other countries are upset about the dollar: It has declined in value precipitously against most other major currencies in recent years. China has held trillions of dollars in Treasury bonds, whose value in foreign currency terms has eroded quite seriously. Eliminating the dollar as a reserve currency would free up capital to hold more stable currencies in countries with healthier fiscal situations.

How to protect yourself
The loss of reserve currency status could hurt the U.S. dollar's value even more. That could leave you exposed to two separate risks: Most Americans get paid in U.S. dollars, so you'd face a stealth pay cut if the dollar fell, and your U.S. investments would lose value compared with foreign currencies.

To protect your assets, there are three strategies to consider:

• Invest in foreign currency. Forex trading is extremely risky, but investing some of your cash in foreign-currency tracking ETFs makes a lot of sense. The CurrencyShares family of ETFs provides exposure to currencies around the world, with each share of the CurrencyShares Japanese Yen (NYSE: FXY) representing about 10,000 yen and shares of CurrencyShares euro (NYSE: FXE) equal to around 100 euro. When local interest rates exceed the expenses of the fund, you'll even get dividends representing the interest on your cash, as with CurrencyShares Australian Dollar (NYSE: FXA).
  
• Own foreign-denominated bonds. Another way to get currency exposure while earning income is to own bonds in foreign currencies. Both government and corporate bonds are available in various forms. Closed-end funds are a popular way to build a portfolio of fixed-income securities. For instance, Templeton Global Income (NYSE: GIM) invests in government debt around the world, whereas you can get more specialized exposure from a fund like Aberdeen Asia-Pacific Income (AMEX: FAX), which focuses mostly on Australia and the Pacific Rim.
  
• Buy stocks with global exposure. Stocks that do business overseas have an edge when the dollar is falling, because their foreign-currency revenue is worth more. You can buy international stocks either individually for those that trade on U.S. exchanges or via ETFs. In addition, Ford (NYSE: F) and McDonald's (NYSE: MCD) are among the many U.S. companies that do enough business abroad that they benefit from a weaker dollar.

Control what you can
As the world moves away from U.S. economic domination, there's little you can do to prevent the dollar's loss of reserve currency status. But you can take steps to preserve your wealth. By diversifying your entire portfolio, you can become part of the global economy -- and benefit from it.

Some of the best investing opportunities are overseas. Find out from Nathan Parmelee why you should bet on Australian stocks.

Fool contributor Dan Caplinger is jealous of his money when it travels the world. He doesn't own shares of the companies mentioned in this article. Ford is a Motley Fool Stock Advisor pick. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. There's no alternative to The Fool's disclosure policy.