Be Smart about Inflation Protection

Christine Benz: Inflation can take a big bite out of any money you have saved. You might think, well, what difference does it make? 3%, 5%, those aren't big numbers. But one way to think about it is in dollars and cents. If you've determined that you need $60,000 a year to survive or to live in your current standard, if you are assuming a 3% inflation rate, that means that in 20 years you'd actually have to have $120,000 to live on the same standard that you're living on now.

So it actually can take a very big bite out of your portfolio over time, and essentially it means that you have to have set aside that much more to keep up with your current standard of living.

What investment vehicles can be used to fight inflation?

A couple of the most common and best, in my view, would be Treasury Inflation-Protected Securities, or TIPS. I think they're a nice, clean way to hedge against inflation risks.

What happens with TIPS or a TIPS fund is that the principal value of your investment adjusts upward along with the inflation rate. In times of relatively benign inflation, like right now, you don't get much, if any, of an inflation adjustment. But when inflation is running hard, you do get relatively more.

So I think TIPS, because they're cheap and relatively specifically directed at inflation, can make a lot of sense for investor portfolios.

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Another thing that you could consider adding to your portfolio is a slice of commodities exposure. There are a lot of funds, and ETFs and exchange-traded notes that make it quite easy to hedge against inflation.

With commodities, I would probably limit them to a smaller slice of the overall portfolio, mainly because commodities as stand-alone investments are extraordinarily volatile. Typically I would say 5% or thereabouts is probably appropriate for an investor looking to add an additional inflation hedge above and beyond TIPS.

What are some of the risks involved with hedging against inflation?

One of the key things I would think about, and I don't think you want to get overly cute about the timing, but do think about whether there is a mad stampede into inflation-fighting instruments. That's probably not the time you want to be adding them to your portfolio.

I think back to mid-2008, for example, or early 2008. Everyone was convinced that inflation was going to be running sky-high for the next decade, and there was this mad dash into not just TIPS, but especially commodities. In hindsight, that was a terrible time to have added those investments to a portfolio.

So I think that anytime that there's mass hysteria about inflation, it's probably the time when you want to keep your cool and not go overboard to the extent that you add inflation protection at that time. Dollar-cost average in versus buying a big lump sum all at once and potentially subjecting yourself to a lot of whipsaw.

What about my portfolio allocation?

One thing I would think about also is looking at what you already have in your portfolio at the time you add additional inflation protection. Again, going back to 2008, you think about a period where there was a lot of concern about inflation. Investors were adding inflation protection to their portfolios.

At the same time, fund portfolio managers were thinking about commodities being on a good uptrend, and so some fund managers were adding a lot of energy exposure to their portfolios at that time. Or international managers were adding to a lot of emerging markets at that time because they saw a very positive price trend going on in commodities.

So be careful. I would say look at your portfolio before adding additional inflation protection because your fund managers may have already been doing it for you.