Devaluation of currency is not uncommon in other countries, but so far has been moderate in the U.S (in part because the dollar is the world’s currency). I recently discussed this in an article titled Speculating on the Future of the Dollar. But given our massive debt, budget deficit and trade deficit, a significant drop of the dollar against other world currencies (and corresponding increase in inflation as all types of imports become more expensive) becomes a possibility.

How can you protect your portfolio from a significant slide in the dollar?
This is indeed a tough question, and I won’t claim to know the answer. However, based on what we’ve seen in other countries, when the value of a currency drops, the value of tangible assets remains roughly the same. In other words, devaluation and inflation go hand in hand.

The consequences for traditional investment vehicles are tough to predict. A value investor might say that stock prices would rise, especially for multinational companies that have significant non-dollar assets. But the stock market is.. a market. And if people are withdrawing money from their mutual funds to cover increased expenses, stock prices will drop regardless of the valuation of individual companies. The same applies at least in part to real estate, though again there are many other factors involved.

In short, you can’t count on stocks, real estate, mutual funds, or certainly dollar denominated or corporate bond funds to protect you from inflation.

So what are your options?

One is TIPS (Treasury Inflation Protected Bonds), that pay a base interest rate and a correction value based on the consumer price index (CPI). Not a bad approach, though there are risks involved for those who are more on the paranoid side – namely, you are trusting the government to accurately calculate the CPI and meet it’s payment commitments on the bonds.

Another traditional approach is gold. Gold is easier to invest in than ever now that you can purchase gold funds (one popular one is GLD). There are two problems with investing in gold. First, it really is a speculative investment – in other words, the price of gold seems more dependent on the action of speculators and governments than on currency values. Second, gold is a rather poor hedge against inflation. If you bought gold at $130/oz in 1975 and sold it at $600 last month, your overall return would be 5.06%, vs. an inflation rate of 4.63% for the same period. Gold might still be a good protective choice (especially if you are concerned about a worldwide depression including a collapse of all currencies, not just the dollar), but as an investment it’s not a particularly good long term play. Gold is also generally taxed as a commodity, not an investment – so you get to pay taxes at the regular rate – which wipes out much of the protection it offers.

You can trade in currency futures. This is just like trading option on the stock market – a technique for more sophisticated investors. I’ve actually done a bit of this, but more as a hedge to prevent a sudden increase of costs when traveling abroad. Currency futures suffer from the same problem as options – they expire. If you’re concerned about a drop in the dollar in the next few months, futures are a great deal. But if you’re concerned about a drop in the dollar over the next 20 years, they are an expensive form of insurance.

A newer approach involves currency ETFs (Exchange Traded Funds). These are funds that hold other currencies. You can now buy ETFs in Euros, Pounds and other major currencies (and a few relatively minor ones). These are especially nice if you’re in the U.S. where it’s typically difficult to trade in other currencies. Their disadvantage is that they really are a pure currency play. The currency in the funds is typically held in accounts that pay little or no interest, so you’re lucky if the fund’s income pays for the fund’s expenses. Another disadvantage is that the IRS considers these a form of commodity trading, and any gains are again taxed as regular income.

Finally, you can invest in an international bond fund. This is my personal favorite. Because the fund’s holdings are generally not in dollars, the fund will tend to do better when the dollar is weakening. At the same time, the fund holds bonds that actually do pay interest – so the fund has income that offsets both expenses and loss in value due to fluctuating interest and currency exchange rates. As a result, you have potentially the best of both worlds – an income fund that at the same time provides protection from a significant drop in the dollar. More important, depending on the individual fund, some of its return will be in the form of long term capital gains (with its more favorable tax rate). Plus, if you hold the fund for over a year and it increases in value, your profits will be taxed at the long term rate when you sell. There is risk – bond values drop as interest rates rise, so I would definitely stick with a short or intermediate term fund if you go that route.

Currency and gold ETF’s are the latest cool investment toy on the block, but frankly, I’m not impressed. Consider using a currency ETF if you’re planning a trip abroad and want to protect yourself from currency fluctuations. Consider a gold ETF for your IRA where the taxation rate isn’t a key factor. But at this time, for a good balance of income and security from a drop in the dollar, a short or intermediate term international bond fund might be just the ticket.