Your Tactics for Fighting Inflation

Inflation is one of the natural enemies of most investors: Think of it as compounding in reverse: What your investment returns give with one hand, inflation can take away with the other.

Mercifully, given all of the other worries investors have had to contend with during the past decade, inflation has been relatively tame. But most Morningstar.com users who posted in response to my recent query in Morningstar.com's Portfolio Design/Management forum don't think the benign inflationary environment will last. Many posters noted that they're expecting inflation in line with historic norms, if not higher, and they've implemented portfolio hedges in an effort to offset its ravages. To read the complete thread, or add a comment of your own, click here.

Expecting at Least Moderate Inflation
Many posters were quick to (rightly) point out that predicting inflation is something of a fool's errand: Like trying to guess the direction of the market or currencies, pinning down the inflation rate requires you to get your arms around myriad impossible-to-predict forces, including the rate of economic growth both here in the United States and overseas.

Philippi noted that not only can it be difficult (or impossible) to forecast inflation, but it can also be hard to predict how various investment instruments will react when prices are on the move. "I try not to let my expectations and assumptions influence my portfolio. I don't forecast very well, and from what I've seen neither do many professionals, either. All the assets react differently and perhaps beneficially to rising inflation except for longer-term fixed income, so it is difficult to identify which ones are here for inflation reasons."

Darwinian gave it to us straight: "It is, of course, impossible to accurately predict inflation, or anything else in the financial realm."

Mesmer quipped, "I have no inflation expectations, since I misplaced my crystal ball a long time ago."

Mwleach, too, acknowledged the difficulty of predicting inflation, but went on to note that factoring in at least a modest rate of inflation is reasonable for portfolio-planning purposes. "According to Ibbotson, inflation has averaged just below 3% per year for the past 84 years. It might be reasonable to assume that we will face around 3% going forward for the next 85 years. The devil is in the details, however. A lot can happen between here and there. The lowest 10-year average we've seen for inflation (U.S.) was from 1926 to 1935--minus 2.6% per year annualized. The highest 10-year average was from 1973 to 1982--plus 8.7% per year annualized. Quite a difference for planning purposes. Given our current economic conditions, I would think that a modest rate of inflation--slightly below the long-term 3% average rather than slightly above it--is most likely during the next decade.

"However, there is one major caveat to my assumption. The temptation to debase a nation's currency in hard times has been a strong and pervasive one throughout history; it is one that I think will be difficult for our current policymakers to resist. In extremis this could lead us to substantial inflation--even hyperinflation. The chances of this happening are low in my opinion, but they are definitely above zero."

FidlStix also thinks moderate inflation--in line with historic norms--over the long term is likely. "In the near term, the next few months, I expect inflation to moderate a bit as commodity prices generally settle. However, in the longer view (several years), inflation has nowhere to go but up. The Federal Reserve can't hold the lid on interest rates forever (can they?). Aside from macroeconomic considerations, I'd expect inflation to climb simply because of reversion to the long-term mean of about 3%."

Poster TMTango is using a long-term inflation rate of 4%--slightly above the historical inflation rates that mwleach cited--as a baseline for long-term portfolio-planning purposes. But he wouldn't be surprised if short-term inflation rates are even higher. "Our long-term financial-planning spreadsheet is based on a growth factor of 6% and an inflation factor of 4%. I think that the long-term projection of inflation at 4% is reasonable, at least given historical measures. I consider the short-term threat of inflation to be a more serious matter, but then at age 70, I am a product of the post-Vietnam experience and recall all too well the inflation and interest rates of the early 1980s when I wasn't able to refinance a house and lost it. However, I don't have the ability to project a number for what I think inflation during the next five to 10 years might look like."

jkimel44, meanwhile, opined that the inflation measures the government uses might not match consumers' experiences. "Are we talking about real inflation, or the government Consumer Price Index? I suspect it is the latter, which has shown essentially no inflation during the past few years due to the heavy influence of housing prices. (Real inflation, for those of us who are retired or working hard just to meet expenses, is easily running at 5%). The government is delighted with the housing-heavy method of calculating inflation, since it means no increases in Social Security payments." He went on, "My prediction for the CPI is a less than 1% increase in 2012; 2% in 2013, and 3% in 2014. My prediction for real inflation is 3%-5% per year for the next three years."

Capecod, always a well-informed voice worth listening to, was the lone dissenter among posters who believe inflation will be mild or worse. He wrote, "I am somewhat less enthusiastic about the course of inflation than the Fed. Specifically, I believe that after peaking in August or September, both core and headline CPI will trend down rapidly, setting off another deflation scare by early 2012." (For more details on the difference between core and headline inflation, check out my colleague Esther Pak's recent article.)

Tips on TIPS
Among posters who noted they were building a portfolio bulwark against higher future prices, several indicated that Treasury Inflation-Protected Securities are their go-to investment.

Poster Jjm62947, for example, is maintaining a robust 30% portfolio weighting in TIPS in the expectation that long-term inflation rates must go up. (He believes inflation is likely to remain level in the near term.)

Chief K, too, is holding a small percentage in TIPS, wisely keeping them within the confines of a tax-sheltered vehicle because of their tax inefficiency. "My only inflation-specific asset is Vanguard's TIPS fund in a Roth IRA for about 5% of my asset allocation. I am slowly increasing that percentage but I don't expect it to go above 10%."

TMTango is also maintaining a modest stake in TIPS. "At the present time we have approximately a little less than 4% of our combined portfolio of $840,000 invested in  Vanguard Inflation Protected Securities (VIPSX) and about an additional 4% in  Vanguard Short Term Bond Index (VBIRX). Our total portfolio at the present time is approximately 60% equity funds and 40% bond funds."

Other posters are much less sanguine about TIPS' prospects. In keeping with his view that deflation could soon be a bigger threat than inflation, Capecod is avoiding the securities. "I currently avoid inflation floaters like TIPS in favor of holding some floating interest-rate debt products because: One, long-duration TIPS will initially drop significantly in price if and when inflation and Fed policy-driven interest rates begin to rise. Two, in response to any serious inflation, short-term interest rates are always driven higher than the inflation rates they are designed to address, and they persist at higher levels longer.

Weiwentg shares capecod's concerns over TIPS' vulnerability in the face of rising interest rates, noting, "I haven't bought any TIPS funds because of concerns over duration risk."

The Real Thing
Other investors who posted in the thread noted that they've used hard assets--directly or indirectly--in an effort to hedge against higher prices. Gold received repeat mentions.

FidlStix is now the proud owner of some yellow metal. "After hemming and hawing for years, while watching the price go nowhere but up, I now 'own' about two thirds of an ounce of gold I'll never see. I've taken a small position in the  iShares Gold Trust ETF (IAU) in my Roth IRA. (I also have a slice of a foreign local-currency bond exchange-traded fund,  WisdomTree Emerging Markets Local Debt (ELD).) As inflation heats up and the dollar weakens, gold will likely keep heading skyward."

PghQuant, too, is looking to real assets to provide inflation protection. "I am skeptical of new financial products that promise to hedge my inflation exposure, as they have no track record to verify. I am also skeptical of inverse bond ETFs as these require excellent timing to properly hedge a portfolio. I am shortening the duration of my fixed-income portfolio and increasing exposure to real assets, such as energy and REITs."

While acknowledging that gold is an imperfect hedge against inflation, mwleach has stuck with his gold position for many years (and has no doubt been laughing all the way to the bank recently). "In our permanent portfolio, I have maintained a 10% allocation in gold-related funds for well more than 20 years. At the end of 2008, I kicked that up to 15% (20% in my IRA), and that is approximately where we are now. Gold and gold stocks are hardly a perfect inflation hedge. However, if things do get out of hand, they should give a significant greater 'bang for the buck' than we would see with TIPS or other inflation-protected securities."

Show Them the Money
For other investors, stocks--specifically those that pay dividends and have the opportunity to increase those payouts over time--are a worthwhile hedge against rising prices.

Jkimel44 likes master limited partnerships. "My methods of fighting inflation are to focus on stocks that not only pay strong dividends, but have a track record of increasing them 4%-6% per year. MLPs top that list."

Poster weiwentg is in the same camp, favoring companies that are able to increase their dividends over time. "I own a significant number of dividend-paying stocks that should be able to increase their dividends faster than inflation. Some, like  Energy Transfer Equity (ETE),  Spectra Energy , and  Realty Income (O), have long-term contracts that specify some sort of inflation protection for the company. Others, like  Abbott Laboratories (ABT),  Paychex (PAYX), and  Procter and Gamble (PG) are just good companies that pay significant dividends. It's an intentionally simple strategy."

Multiple Choice
For other investors who posted in the thread, there's no silver bullet for hedging inflation risk: They've combined multiple investments that they believe will have inflation-fighting characteristics.

Darwinian, always in favor of diversification and a well-considered approach to asset allocation, wrote, "Fortunately, a good asset allocation does not need very much fine-tuning to meet the threat of inflation. Value stocks are good investments any time, and are even better during inflationary surges. A diversified bond allocation should normally include 33%-50% TIPS; I increased mine to 66%, several months ago, to accommodate the increasing inflationary risk. I took a small position in energy stocks, more than a year ago, not just because I expected their excellent subsequent performance, but primarily because the Morningstar X-Ray tool showed me that they were underweighted in my portfolio. This asset class was undervalued at the time. Other investors considering such moves now should be aware that it might already be too late to benefit."

Diaman is also taking a diversified tack to hedge against inflation, including dividend-paying equities, short-duration bonds, and foreign equities "denominated in a mixed bag of currencies (euro, sterling, Swiss francs, and dollars)."

Philippi, meanwhile shared specific allocations for his portfolio, including large positions in U.S. and foreign stocks and high-quality bonds as well as smaller stakes in gold, commodities, REITs, and TIPS.

BuyerBeWare's portfolio also includes a grab-bag of investments that he believes have the ability to hang tough in the face of rising rates, including  T. Rowe Price New Era (PRNEX) (a natural resources fund),  USAA Precious Metals (USAGX), and some individual food companies. He also has small positions in  Vanguard REIT Index (VGSIX) and Vanguard Global ex-U.S. Real Estate Index , but recently he cut the former position out of concern that the U.S. REITs are overheated as income-starved bond investors have swapped into them.

Poster mesmer, while skeptical about his own ability to predict inflation, writes, "I have 20% of my portfolio positioned as an inflation hedge. Half of this (10%) is specific equity holdings (alternative energy 5%, the other 5% spread among funds such as T. Rowe Price New Era,  Vanguard Precious Metals and Mining (VGPMX), and  Vanguard Energy ETF (VDE)); the other half (10%) is in nonequity positions, primarily in TIPS,  PowerShares DB Agriculture (DBA), and  SPDR Gold Sares (GLD)."

Rathgar is also taking a diversified approach to beating the inflation threat, writing, "Inflation hedges have been real estate at 5%,  PIMCO Commodity RealReturn (PCRAX) at 4% (this fund is a dual inflation hedge with commodities and TIPS), global bonds at 5% (expecting a declining dollar),  iShares Barclays TIPS Bond (TIP) or Vanguard Treasury Inflation-Protected Securities at 5%, and bond funds with shorter duration. U.S., international-developed, and emerging-markets stocks should also benefit from inflation in the long run due to inflation-adjusted earnings. Lastly, maintaining long-term low interest-rate mortgages on rental property and home expecting housing (some day) to return to 3% to 4% appreciation rates or in line with inflation."

A grab-bag of sectors fit into cgkern's inflation-hedging strategy, including REITs, energy, and consumer staples. But also as notable is what this 55-year-old is not buying. "No bonds since they are unlikely to beat inflation or hold their value in a rising interest-rate environment."

Poster rdoucette, meanwhile, is putting off an annuity purchase. "Although I am mostly retired, my concerns about future inflation have caused me to postpone buying an annuity (which I would like to do)." Rdoucette has rightly homed in on the fact that unless you buy a variable annuity or a fixed annuity with inflation protection, the payments you receive from a fixed-rate annuity will decline in real terms each year that inflation increases.

Finally, mwleach offered this bit of wisdom for determining how concerned you should be about inflation. "In general, I would recommend investors look at their income from all sources, determine how future inflation (or lack thereof) would affect those as well as their investments, and then take action. Inflation is only one of the problems we face going forward--but it could be a significant one, and it is one all investors should be addressing."

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