The Japanese and Chinese economies are so large that their currencies deserve special attention. The Chinese currency is fixed to the U.S. dollar by Chinese government mandate. China runs a significant current account surplus. There is speculation (both whispered and in the futures prices) the dollar will eventually weaken against the Chinese currency (known as yuan, it is officially called renminbi or RMB).

The large current account surplus of China suggests that the dollar will fall in comparison to the yuan. What about the Japanese yen? In 1980,1 saw a talk by Douglas Fraser, then president of United Auto Workers. Fraser said that the reason Japanese cars sold well in the United States was because the dollar was too strong against the yen. At the time, you could buy more than 250 yen for one U.S. dollar. If only the dollar would weaken to about 200 yen, Mr. Fraser suggested, American-made cars would be a better value than those made in Japan.

The U.S. dollar soon weakened to far beyond Mr. Frasers target and currently fetches about 110 yen. In spite of this weakening of the dollar, Japanese cars and other products remain so cheap that Japan runs a large current account surplus with the United States. Thus, the expectation is that the U.S. dollar will continue to weaken against the yen.

Furthermore, both the Japanese and Chinese currencies are kept at artificially low levels by their governments. Because such government interventions always fail in the long run, these currencies are likely to rise to their correct levels over time. The Bank of England attempted to keep the British pound at artificial levels in 1992. Speculator George Soros earned a reported $1.1 billion by betting that the Bank of England could not maintain artificial levels-he was right. So the dollar is likely to fall against the Japanese yen and the Chinese yuan.

Putting these facts together, I conclude that the decline in the dollar that began in 2001 is not over.

The U.S. current account deficit remains near its historical high. Furthermore, sentiment toward the dollar is not negative enough for a market bottom. Recall that at market extremes, our lizard brains tend to be exactly out of sync. Even if rational financial calculations suggest that

the dollars decline is over against some important currencies, mean markets dont stop at fair value. Just as the dollar became wildly overvalued before it stopped rising, the science of irrationality suggests that it will have to become undervalued (and scorned by experts) before its decline can end.

How to Invest in a World with Fluctuating Exchange Rates

Cartoon characters have neat tricks that help them avoid disaster. When one of our heroes is trapped in a falling house, the solution is simple. Just as the house is about to crash into the ground, Bugs, Daffy, the Road Runner, and others simply step out of the house. They walk away from the wreck with nary a scratch.

While we cannot exit falling houses without injury, we can leave behind declining currencies. For the last few years, my wife and I have owned a good-sized position in bonds issued by the German Central Bank. The bonds pay low interest rates of no more than 4.5% annually. In spite of the low interest rates we have been earning more than 10% a year on our German bonds.

The payoff from owning euro bonds is the interest rate plus the change in the currency. For example, we bought some of these German bonds in 2001. At the time each U.S. dollar bought 1.1 euros. For each $1,000 that we invested we received more than 1,100 euros worth of bonds. When those bonds matured a year later, the 1,100 euros had grown to 1,133 euros (3% interest rate). Furthermore the dollar had declined in value so the dollar value was almost $1,150. So in one year these euro bonds earned 3% interest plus more than 10% in currency change for a 15% return.

To avoid being hurt by a falling U.S. currency, the goal is to escape the falling house. The protection is to own investments in nondollar currencies. A simple and effective solution is to buy non-U.S. stocks and non-U.S. bonds.

There are two subtleties to this guidance. First, a companys exposure to the dollar is not determined by the location of its corporate headquarters. For example, Toyota may have more exposure to the U.S. dollar than does Microsoft. Toyota sells a lot of cars in the United States, and Microsoft sells lots of software outside the United States. So the definition of a non-U.S. stock depends on the location of sales.

Second, a declining dollar puts pressure on foreign companies. For example, the weakening dollar has made German goods less attractive and consequently fewer German workers have jobs. Remember that the U.S. current account shrinks when Americans stop buying Italian handbags and German cars. That means the companies who make Italian handbags and German cars need fewer workers. The savvy investor has to escape the effects of the falling dollar both within the United States and in other countries.

How much should be invested in nondollar assets? My advice for the average investor is 15% of net worth. To minimize risk of currency fluctuations, I suggest that people align their investments with their buying behavior. For example, the average American spends about 15% of her or his income on foreign goods. Thus, a completely reasonable, and low-risk strategy suggests that 15% of an investors net worth be invested in nondollar assets. Those who want to speculate with me on a further dollar decline, and those with a taste for foreign goods, could allocate even more to foreign investments.