Don't Let This Threat Wipe Out Your Gains

Even with the stock market's huge rally over the past year, you've heard plenty of scary economic news coming out of Washington. Yet as investors have expanded their horizons to try to capture what may be the biggest investment opportunity of the generation, they've left themselves open to a huge risk -- one that's more likely to bite them than they might believe.

Returning from the grave
Let's face it: Most people have pretty much given up on the prospects for the U.S. dollar going forward. Soaring budget deficits, a slow economy that hasn't yet responded strongly to all the stimulus money that's been thrown at it, rock-bottom interest rates, and inflationary concerns have all conspired to lead investors to give up the dollar as dead.

In response, investors have gone elsewhere to look for big gains. International stocks, especially in emerging markets, have paid extraordinary returns since their lows last year. Gold, oil, and many other commodities have continued their bull run after a huge correction in late 2008. Yet in doing so, they've assumed that the dollar won't recover. That's the risk that they aren't counting on -- and it could end up hitting them hard.

The big bounce
In December, the dollar gave investors a hint of what could come in a potential rebound. From Dec. 1 to Dec. 22, the dollar index rose about 5%, as signs of a growing U.S. economy ignited predictions of sooner-than-expected interest rate increases that would make the dollar look more attractive compared to foreign currencies. During that three-week period, the S&P 500 rose about 1%. But quite a few international stocks didn't fare nearly as well:

Source: Yahoo! Finance.

Reflecting the broader international markets, one emerging-stock ETF dropped more than 2% over the period, and a world stock index fell almost 3%.

What goes down must come up?
In the grand scheme of things, December's movements in currencies were relatively mild. More dramatic dollar appreciation could come when interest rate rumors become fact. Many, including economist Nouriel Roubini, have argued that low rates in the U.S. have spawned carry trading that is in turn creating asset bubbles worldwide. When the Fed inevitably starts raising short-term rates from the 0% level, those trades will start to unwind -- and the dollar could be a big beneficiary of that move.

That doesn't mean that foreign stocks are a bad play. Some foreign stocks actually benefit from a strong dollar, especially those that send goods to our markets. Conversely, some U.S. stocks with a big international presence, including PepsiCo (NYSE:PEP) and IBM (NYSE:IBM), can suffer when the dollar is overly strong.

What it does mean, is that you should consider hedging your foreign investments to eliminate currency risk. That's a strategy that a new exchange-traded fund (ETF), the WisdomTree Hedged Equity Fund (HEDJ), plans to use to protect shareholders from a rising dollar. Like any other foreign fund, the WisdomTree ETF looks for investments it believes will rise in value in local currency terms. Instead of leaving itself open to foreign exchange fluctuations, however, it enters into separate transactions to neutralize its foreign currency risk, counting instead on pure appreciation from its stock positions to provide gains.

Get diversified
Of course, if you don't have a lot of foreign stock exposure in your portfolio, then you're already betting on the dollar's strength over the long haul. In that case, adding foreign stocks to your portfolio is a smart move, even with the foreign currency risk. Even if dollar bulls prove correct, the added diversification will lower the overall risk across all your investments.

But if you've been chasing the amazing performance of international stocks both in 2009 and over the past several years, you might want to consider the possibility that the dollar's woes may reverse themselves. If you're prepared, you can reap the best of both worlds and maximize your profits while keeping your portfolio oriented toward increasing globalization in the world economy.

There's a big danger to investors dead ahead, but there's something you can do about it. Let Fool Nick Kapur show you how to avoid the iceberg that will sink your portfolio.