Last Updated Apr 16, 2009 6:34 PM EDT
We can look at history, because we actually have a case where the world's reserve currency lost its status. Prior to the dollar taking that role, the British pound was the world's reserve currency, a status it lost shortly after World War II. Not only that, but Britain's industrial capacity was devastated because of the war. So how have British stocks performed? We have data on the FTSE All-Share Index going back to 1955. Given these conditions you'd think that U.K. stocks would have done very poorly relative to U.S. stocks. And you'd be dead wrong. From February 1955 through March 2009 the FTSE All-Shares Index returned 11.5 percent, outperforming the S&P 500 Index, which returned 9.4 percent.
Yes, it's possible that the Chinese could abandon the dollar. And one concern you'll hear is that a falling dollar will lead to high inflation. While that's possible, it's certainly not inevitable. Consider that the dollar experienced a dramatic drop from under $0.90 against the Euro to $1.60 (before rallying to around $1.35). Yet, during that period, when the dollar fell by about 80 percent against the Euro, the U.S. experienced very little inflation.
One reason is that trade is a very low percentage of our GDP. Clearly, a falling dollar does not mean that high inflation is inevitable. And a falling dollar can also have some positive effects, such as narrowing the trade deficit by making U.S. imports more expensive and exports cheaper. It's nearly impossible for anyone to net out those potential effects with any precision.
With that in mind, your best strategy is to build a globally diversified portfolio, including a healthy allocation to international equities (unhedged for currency risk). I recommend an international allocation of 40 to 50 percent. The second recommendation is to minimize the risks of inflation. One of the best ways to do that -- at least for tax-advantaged accounts -- is to invest in TIPS. For taxable accounts, avoid longer-term bonds.
Further reading: My MoneyWatch colleague Charles Wallace recently weighed in on Why China Won't Dump the Dollar Any Time Soon.
Dollar-bill snail image via Flickr user RangerRick, CC 2.0