Declining U.S. dollar produces good, bad trade-offs

This article was produced by the Financial Planning Association and provided by William O. Woody of Stovall Woody Associates.

You may have recently read or heard numerous references about the falling dollar, and not paid them much attention but perhaps you should. People who travel overseas, invest domestically or internationally, or who buy imported products will be affected by the falling U.S. dollar.

The falling dollar refers to the fact that the exchange value of the American dollar has been declining sharply against several major world currencies over the last couple of years.

The American dollar, for example, lost 20 percent in buying power in 2003 against the euro, 10 percent against the yen and 34 percent against the Australian dollar, according to numbers from the Wall Street Journal.

The American dollar also hit an 11-year low against the British pound and a six-year low against the Canadian dollar. In short, the buck buys less abroad than it once did.

The impact of this decline produces both good and bad trade-offs for American consumers, depending on their investing and spending habits. Here are some major impacts, as well as changes you might make in your finances to minimize or take advantage of them.

More expensive consumer goods. Many goods Americans buy, from cars to electronics to apparel, are imported. The prices of those products inevitably rise as the value of the U.S. dollar declines. But fear of losing market share in the United States has compelled many foreign companies to absorb some of the currency increases by reducing their profit margins. And some "foreign" products, such as many Asian cars, are actually manufactured in the United States. Still, numerous imported products have risen in price. The obvious counter strategy, of course, is to buy American.

Travel costs more. It's a cold fact that hotels, meals and tourist sights are going to cost more for American travelers to Europe, Japan, Canada and Australia, among other nations, because their dollars won't buy as much of the local currency as they have in the past.

You could either delay travel until the dollar strengthens or buy American by traveling in the United States. Or, as should be noted when discussing the impact of the falling dollar, it isn't falling everywhere. The dollar, for example, has risen against the currencies of Mexico and several Latin American nations, making them cheaper travel destinations.

Investing. While you may not want to travel overseas soon because of the cost, you may want to send your money there. Many foreign stocks and bonds have performed well for U.S. investors, and no small part of those good returns has been due to the dropping dollar.

Most who invest internationally do so through U.S.-based mutual funds, and they should pay special attention to what nations or regions a fund invests in, and how the fund handles currency fluctuations.

Some funds fully or partially hedge against currency swings, up and down. This reduces fund volatility for investors. But hedging also costs, reducing the return for fund investors. Furthermore, some experts point out that hedged funds correlate more closely to U.S. dollar investments than unhedged funds, thus undercutting some of the benefit of diversifying internationally.

On the domestic investment side, a weak American dollar is good for those American companies small ones as well as the huge multinational corporations that sell a lot of their product abroad. Exported American products are cheaper, and thus more competitive, and when those increased international sales revenues are converted to U.S. dollars, they can take advantage of the favorable exchange rates, further boosting profits.

Financial planners still caution you should be wary of "chasing performance." Many experts predict that the U.S. dollar will remain weak for much, if not most, of 2004. But the risk here, naturally, is that they could be wrong, and the dollar might unexpectedly begin to rebound against foreign currencies. That would hurt international investment returns and returns of American companies that do a lot of business abroad.

Ultimately, most investors should look long-term. For one thing, currency fluctuations generally even out over time. Second, the primary benefits of devoting a portion of your portfolio to overseas investments, (perhaps 10 percent or 20 percent) is not to ride the winds of currency fluctuations, but to diversify and actually reduce overall investment risk, and to buy into good companies abroad.