My last post addressed the concerns investors had about the dollar potentially losing its status as a reserve currency. Today, we'll take a look at what actions you might consider taking if that was a risk about which you are concerned.
First, you could increase your allocation to international equities. For example, in the case of my firm Buckingham, our model portfolios, which we use as a starting point for discussions with clients, includes a 40 percent allocation to international equities, of which 30 percent is allocated to developed markets and 10 percent to emerging markets (the 3:1 ratio of developed to emerging markets is in line with their relative shares of the global equity market). U.S. stocks currently constitute less than 50 percent of the global market capitalization. However, some home country bias can be justified because international investing is a bit more expensive (both in terms of fund expense ratios and trading costs), hence the 60 percent domestic allocation with which we begin conversations.
With that said, if you are concerned about the value of the dollar falling, you could increase your international allocation from 40 to 50 percent, or perhaps even 60 percent (which would be more in line with the current market capitalization). It's important to note that the mutual funds you use shouldn't be hedging the currency risk (as for example Tweedy Browne does in their international funds), as it's a risk you want to have.
Second, increasing your international exposure would not only reduce the risks of a falling dollar, but it would actually create a portfolio with higher expected returns. Using the Shiller CAPE 10 yield, we are currently estimating real returns as follows: U.S. stocks 4.2 percent, developed market stocks about 6.4 percent, and emerging market stocks about 7.1 percent.
Again, these are real expected returns. Based on these estimates, tilting your portfolio more to international stocks increases the expected return. However, that shouldn't be viewed as a free lunch. The market believes that international stocks are currently riskier. Thus, they have lower valuations and higher expected returns. However, there are other reasons you might want to consider a higher international allocation.
An important factor that should be considered in deciding on your asset allocation is one that is often overlooked because it's an asset that doesn't appear on any balance sheet - your labor capital. And if your labor capital correlated with the economic risks of owning U.S. stocks more than it's correlated with owning international stocks (which is likely the case for most Americans), tilting your portfolio more to international stocks serves to diversify your labor capital as well as your domestic equity exposure. The larger the percentage of your labor capital relative to your total assets, the more it should be considered in your asset allocation. And the younger you are, the larger the percentage is likely to be. This topic is discussed in detail in my book, "The Only Guide You'll Ever Need for the Right Financial Plan."
Third, you could either add an allocation to commodities or increase your current allocation to them. The reason is that because commodities are dollar denominated, a falling dollar reduces the price of commodities in foreign currency, increasing demand, pushing up prices. Secondarily, the real risk of a falling dollar is if the depreciation is caused by rising inflation - which is a monetary, not currency phenomenon. Commodities are not only positively correlated to inflation, but they tend to perform best when inflation is rising. My personal preference is for an investment in a broad commodity index such as the DJ-UBS Index. However, some people prefer to invest specifically in gold. Or, you can do a combination of both.
A fourth option would be to add a global, unhedged bond fund to your bond allocation. The benefit would be that you would gain some diversification of real interest rate risk as well as some hedge against a falling dollar. However, the currency risk added would be expected to increase the volatility of the portfolio.
A fifth option would be to increase your allocation to TIPS and/or shorten the maturity/duration of your nominal bond holdings. Both of these actions would reduce the risk of unexpected inflation, assuming that was the cause of the falling dollar.
Before concluding I offer two words of caution. First, if you are going to make any of these changes you should amend your current investment policy statement (IPS) and make the changes permanent. And you should make them only if they are truly based on your assessment of what risks you are exposed to. You don't want to be making changes based on anyone's economic or market forecasts (including your own). The reason is the evidence demonstrates that there aren't any good forecasters - which is why Warren Buffett advises that you should ignore them all, as he does. Second, if you do increase your allocation to international stocks, make sure you won't be subject to that dreaded psychological disease we refer to as tracking error regret. Tracking error regret arises when your portfolio underperforms the returns of U.S. benchmarks like the S&P 500 Index, which you hear about daily, reminding you of your "error." However, smart investors are never subject to tracking error regret because they don't make the mistake I refer to as "confusing strategy with outcome." Nassim Nicholas Taleb, author of "Fooled by Randomness," put it best when he said:
"One cannot judge a performance in any given field by the results, but by the costs of the alternative (i.e., if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision)."
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.