The modern investor has a wealth of new tools to achieve real diversification. Small investors are encouraged to spread their portfolios across a range of stocks and bonds. Small caps, mid caps, large caps, value, growth, short and long-term Treasuries, and municipal bonds have been the staple of a diversified portfolio. Well, times have changed and so too should your notions of eggs and baskets.



Exchange-traded funds (ETF's) change the old notions of portfolio management. Individual investors can now add commodities (precious metals, corn, wheat, soy, cattle, oil, natural gas, etc.), currencies, and specific sectors of the economy just as easily as they can add stocks.

A great way for American investors to hedge inflation and the decline of the dollar is to purchase currency ETF's. These instruments enable investors to gain exposure to specific foreign currencies, which are often uncorrelated to US stocks and bonds.

Overall portfolio risk can be measured in the variance of returns, which is a function of the individual assets held. To decrease total system variance it is best to include assets that are negatively correlated to each other.

Someone holding predominantly US stocks in their portfolio should consider adding currencies that are negatively correlated. It turns out that Swiss Franc, Japanese Yen, and Swedish Krona move in opposite directions as US stocks, while Australian dollar, Mexican Peso, and Canadian dollar move in the same direction.

Including the negatively correlated currencies over the last year would have seen between 12% and 17% capital gains. This is due merely to appreciation relative to the US dollar. In addition to relative currency gains, each ETF offers dividends representative of each countries interest rates.

There are multiple consderations in portfolio theory, but applying the basics can have far reaching benefits. Those concerned with dividends should hold the highest yielding ETF's, which include British pound, Australian dollar, and Mexican peso. On the flip side, income investors should avoid Swiss Franc and Japanese Yen.

In a world of increasing energy and food price inflation, you can see how important it is to hedge these risks. Currency ETF's offer such an opportunity; exposing investors to relativer currency price movements, as well as variable income opportunities from taking advantage of interest rate disparities in foreign markets.