Over the past year, the U.S. dollar has weakened relative to foreign currencies, falling to an all-time low against the euro and multi-year lows against the British pound and Japanese yen.

Who Wins, Who Loses?

The most obvious impact of a falling dollar is that it lowers the price of what we sell overseas. Beneficiaries of a weak dollar include American companies that sell goods and services abroad (exporters) and foreign firms or individuals that buy them.

Conversely, foreign-made products are now more expensive in the U.S. For example, Americans are paying more for Japanese electronics and French wine. A weak dollar also hurts American companies that buy goods from overseas, as well as the foreign exporters who sell them. And forget about that European vacation you were contemplating.

Investing

U.S. investors in foreign-denominated securities benefit from a declining dollar because it boosts the total return on international investments. There are three convenient ways to invest in foreign stocks. You can buy American Depository Receipts (ADRs), which represent shares of stock in foreign companies. ADRs trade over the major U.S. stock exchanges and can be bought and sold like any other listed stock. However, there are a limited number of ADRs representing only the largest foreign companies.

Another alternative is to buy shares in international mutual funds. This approach provides a wider selection and more diversification than ADRs. Some fund companies use futures contracts to mitigate the effects of foreign currency fluctuations. However, the DFA funds that we use in our client portfolios are unhedged. As a result, the performance of these funds has benefited from the recent dollar decline. For example, the DFA Small Cap Value fund was up 25% in 2004.

Finally, investors can use exchange-traded funds (ETFs) to invest in foreign securities. Barclays Global Investors has become the major provider of ETFs through its iShares series. These funds are not hedged for currency risk and therefore offer exposure to foreign currency movements.

Asset Allocation

Rather than focusing on fluctuations in the value of the U.S. dollar, you should base your asset allocation decisions on more stable considerations, such as your risk tolerance and investment time horizon. Using foreign-denominated assets to play the currency market is a foolish endeavor for most investors. A better reason for investing in foreign securities is diversification. Non-U.S. companies account for about half the world's market capitalization. Foreign stocks do not move in lockstep with the U.S. market, in part because of currency swings. As a result, adding foreign stocks to a portfolio improves diversification and decreases volatility over time. Our recommendation is to maintain a well-diversified portfolio, including both domestic and international securities, and not to worry too much about the value of the U.S. dollar.

January 2005

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