The Short Answer

How to Inflation-Proof Your Portfolio

Christopher Davis

Ben Bernanke, the chairman of the Federal Reserve, is worried about inflation. Rising energy costs could work their way into the costs of other goods and services, he fears, leading to higher inflation. There are signs that this is already happening. In May, the Consumer Price Index, the most common measure of inflation, rose 4% more quickly than the year before, a level above which most Fed watchers think Bernanke would be comfortable with.

Inflation isn't something only Bernanke should be worried about. Even moderate inflation can take a heavy toll on your nest egg. Let's say inflation averages 3% over the next 30 years--a rate not far from the Fed's long-term target. By the end of those three decades, $100,000 would be worth just $40,000 in today's dollars. Higher inflation poses an even more serious threat. If inflation clocked in at 6%, the purchasing power of $100,000 would fall to just $17,000. At 10%, $100,000 would be worth a meager $5,700 in today's dollars.

What can you do to guard your portfolio against the ravages of inflation? Here are some ways you can protect yourself.

Tilt Your Portfolio Toward Stocks
You're probably thinking that staking more in stocks is a bad idea if you're concerned about inflation. After all, the stock market's recent swoon got started when Bernanke went public with his inflation concerns. Investors fear the new Fed chairman will go too far in raising interest rates and squelch economic growth in order to prove his inflation-fighting bona fides. Heightened inflation expectations also translate into higher interest rates because lenders want to make sure the value of their loans isn't eaten up by inflation. Higher rates also make it more expensive for businesses to borrow, which in turn slows economic growth. And with higher rates and a slower economy, stocks suffer--at least in the short term.

Looking long term, however, inflation may have a more neutral effect on stocks. Stocks for the Long Run author Jeremy Siegel points out that stock returns historically have been immune to the inflation rate over long stretches of time. Although rising prices could crimp profits in the short term, Siegel argues that companies--eventually--can pass on those costs to consumers, making inflation a wash for stock market returns.

Even if the effects of inflation aren't as benign as Siegel presumes, stock investors are likely to fare better in an inflationary environment than bondholders. With fixed coupons and principal payments, inflation takes an especially heavy toll on bonds (though as you'll see in the next section, not all bonds suffer in an inflationary environment). Stocks, though, have greater return potential than bonds, giving you a better shot at beating inflation.

It's true that favoring stocks over bonds does expose your portfolio to more volatility, but don't lose sight of other risks. Especially as life expectancies improve, there's the increased possibility that you'll outlive your assets. And inflation makes that challenge an uphill battle. Betting on stocks may seem like a risky, aggressive move, but doing so to make sure your portfolio lasts at least as long as you do is more a defensive move.

Invest in TIPS
Most bonds pay interest on a principal amount that is fixed. When the bond reaches its maturity date, the principal, or face value, is repaid to creditors. But thanks to inflation, this amount won't be worth as much in "real" dollars as it was when you first invested it.

One solution to this dilemma is to invest in Treasury Inflation-Protected Securities, or TIPS. Issued by the U.S. government, TIPS provide virtual immunity from defaults, just like plain-vanilla Treasury bonds do. However, they are unlike traditional Treasuries in one important respect: If inflation rises, so will your principal. That's because TIPS' underlying principal readjusts every six months along with to the consumer price index, or CPI. As a result, the real purchasing power of your investment in TIPS will keep up with inflation.

You can buy individual TIPS directly from Uncle Sam through Treasury Direct or through mutual funds like Vanguard Inflation-Protected Securities (VIPSX) or PIMCO Real Return  PRRDX.

An alternative to TIPS is U.S. Treasury-issued I-Bonds. I-Bonds are also geared to offer inflation protection, but unlike TIPS, it's their interest rate, not underlying principal, that fluctuates along with prices. Interest from I-Bonds comes from two components, a fixed and variable interest rate. The fixed rate is set at the time of purchase, while the variable rate is tied to the CPI. I-Bonds are available directly through Treasury Direct.

I-Bonds have some tax advantages over TIPS for investors in taxable accounts. They're also available in increments as low as $50 (TIPS start at $1,000). To learn more about the differences between TIPS and I-Bonds, check out my colleague Sue Stevens' column on the subject by clicking here.

Don't Rely on Commodities or Real Estate for Protection
The conventional wisdom is that gold, other commodities like oil and copper, and real estate provide a shield against inflation because the prices for these assets often surge at the very same time inflation does. As is often the case, the conventional wisdom has a grounding in fact: Inflation climbed to double digits in the 1970s, and the price of gold and other commodities soared. Real estate, too, rose sharply. While gold and real estate rose, stocks delivered subpar returns.

Based on the experience of the 1970s, investors worried about inflation today might be tempted to dump stocks and buy gold, oil, and real estate. Yet how well those areas fared in the past may not always be a reliable guide to the future, meaning that commodities, gold, and real estate are at best an imperfect hedge against inflation. Take gold, for instance. Investor worries over inflation have sent stocks reeling over the past six weeks, for instance, yet the price of gold has tumbled. After peaking in May at $730 an ounce, gold is down to about $585 an ounce. In May alone, precious-metals funds (which mostly invest in gold stocks) sunk more than 9% on average.

It's also possible that some asset classes that are typically thought of as inflation hedges, such as real estate, really aren't. Real estate investor and Investing in REITs author Ralph Block argues that real estate's strong performance in the inflationary 1970s could have been coincidental. Sure, real estate values rise in inflationary environments, but so do operating costs like maintenance and insurance, Block points out. Inflation also typically leads to increases in interest rates, which reduces the value of real estate by increasing borrowing costs and by making other, safer income-oriented investments relatively more attractive. While real estate holds its value well against inflation, Block argues it doesn't do so any more effectively than stocks.

The case for real estate--or commodities for that matter--really hinges more on its ability to diversify a portfolio rather than for its inflation-fighting traits. Both real estate and commodities tend to zig when stocks zag, making exposure to them beneficial even if they don't guard against inflation any better over the long haul. My colleague Karen Wallace recently addressed some of the pros and cons of commodities and highlighted some of our favorite commodities-related investments.

Like stock market returns, economic growth, or interest rates, inflation is one of those variables you can't control. So rather than grouse about the prospect of higher inflation, focus on things you can control. You can control what you own, so diversify your portfolio to include TIPS, for example. You can control how much you pay for your investments, so stick with low-cost funds. If higher inflation lurks in the future, don't make it even harder for your portfolio to keep up by saddling it with the burden of high expenses. While inflation isn't something to be desired, it's something you can learn to live with.

Christopher Davis does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.