Why would a firm consider investing in a portfolio of foreign currencies instead of just a single foreign currency?

Over the past year, the dollar has been on a tear: The U.S. Dollar Index, which measures the dollar's strength against a basket of foreign currencies, is up 18%.

For tourists, a strong dollar is great news. It means you get more for your money abroad.

But for investors, a beefed-up buck is decidedly bad news.

"When the dollar strengthens, that means foreign revenues are going to translate into fewer dollars. Those earnings are going to come in lower," says Sam Stovall, chief investment strategist at CFRA Research, adding that any overseas investment you own "is going to hurt you in a rising dollar environment."

Here's why investing experts say a strong dollar could hurt your portfolio, and what you can potentially do about it.

How a strong dollar hurts your portfolio

A strong dollar crimps income that companies earn abroad, since money brought in in the form of weaker foreign currencies is converted into fewer dollars.

The effect on your portfolio is directly related to your international exposure, which could be greater than you think. About 30% of revenues in the S&P 500 — a barometer for the broad U.S. stock market — come in from overseas, analysts at investing firm Evercore report.

If you own a collection of international stocks — a commonly recommended way to diversify your portfolio — the drag on performance is even more apparent.

"U.S. investors who own international equities get punished by the strong dollar because they're not getting the benefits of a local market," says Todd Rosenbluth, head of research at investing analytics firm VettaFi. "The dollar has significantly weakened the performance of international strategies this year."

Case in point: The MSCI EAFE Index, a benchmark for stocks from developed foreign countries, has surrendered more than 20% so far in 2022. A version of the index that strips out the effects of currency fluctuations has lost about 7.5%.

How to adjust your portfolio for a strong dollar

As with any short-term development in the market, advisors recommend against making wholesale changes to your portfolio or straying from your long-term investing plans. But if you're looking to take action now against the effects of the strengthening dollar, experts say you can make a few tweaks to your portfolio.

Among your U.S. stock holdings, shifting your allocation toward small- or midsize-company stocks can lower your exposure to the multinational corporations for which the dollar represents the biggest drag.

You may also want to consider bolstering your holdings in sectors of the economy less likely to rake in profits from overseas, Rosenbluth says. "Sectors like utilities and real estate tend to tend to have the majority, if not all, of their revenues stemming from the U.S., whereas staples and health-care companies are more multinational."

As for your foreign holdings, you can buy funds that follow "currency-hedged" versions of international stock indexes. The managers of these funds trade derivatives to remove the effects of currency fluctuations from the returns of the underlying stocks.

"It allows you to focus solely on the performance of the individual companies in the fund," says Rosenbluth.

These funds will tend to lead their unhedged counterparts during periods of dollar strength and lag behind during periods of dollar weakness, but over long stretches, the return you earn from a hedged versus an unhedged product tends to be relatively similar, a 2020 analysis from Morningstar found.

A few other nuances separate hedged and unhedged funds, and the decision to hold either is ultimately a matter of preference, says Rosenbluth.

But don't buy one or the other in an effort to time currency fluctuations for short-term gains, he warns: "You're just as unqualified as I am in projecting whether the dollar will continue to strengthen over the next 12 months."

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