How to protect your portfolio when inflation is on the rise
How bad is inflation for your portfolio? Let us count the ways.
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How bad is inflation for your portfolio? Let us count the ways.As consumer prices rise, the Federal Reserve and the issuers of bonds hike up interest rates. That brings down the value of the bonds you already own. Your stocks' earnings start to look less attractive compared with the latest bond yields, which puts downward pressure on share prices. What's more, the inflation-fighting Fed may push the economy - and corporate profits - into a slowdown. So when inflation pops up, every investor who can read the news starts looking for protection.That's what's happening now. Investors have already flocked to investments whose main selling point is their inflation protection, and that has pushed up their prices. "Many of the best inflation hedges look overvalued," says Ross Levin, a financial adviser in Edina, Minn.So instead of piling into pure hedges like inflation-protected bonds and commodities, treat them like an insurance policy, buying just enough to protect yourself in case prices get out of hand. That insurance will be only one part of a portfolio designed to grow no matter what the CPI does.In short, you still need stocks - especially companies with the power to pass on higher prices. How you should blend the hedges in your portfolio depends on how close you are to retirement. But first take a look at how each inflation fighter works and the best ways to buy.1. Tips: The (low-return) sure thingTreasury Inflation-Protected Securities, or TIPS, are the one guaranteed hedge against rising prices. With TIPS, your principal is adjusted upward every six months to keep pace with the consumer price index. The bonds carry a fixed coupon rate lower than that of Treasuries of similar maturity. But the dollar amount of the payment increases as your principal value is adjusted upward.Say you buy $10,000 of five-year inflation-protected bonds at today's 1% rate - that's $100 in yearly income. If inflation rises 3% in the first year, your principal will increase to $10,300, and now your 1% payment will total $103.Investors snapped up the supersafe bonds when the credit crunch hit, pushing down yields. At 1%, today's five-year TIPS yield is 2.2 percentage points below the 3.2% rate for a conventional Treasury. In other words, at this price, inflation has to top 2.2% a year over five years for TIPS to beat other Treasuries. Four years ago inflation needed to top only 1.5% for TIPS to be the winning bet."Now may not be the time to put a lot of new money into TIPS," says Ken Volpert, head of fixed-income investing at Vanguard. Still, 2.2%-plus inflation is hardly implausible, so if you're in or near retirement, you may want to devote about 15% of your portfolio to these bonds.How to invest If you don't already hold a stake in TIPS, move in gradually now. You can buy them from the U.S. Treasury or through a fund such as Vanguard Inflation-Protected Securities. TIPS are best held in a tax-deferred account, such as a 401(k), since otherwise you will owe taxes on the inflation adjustment.2. Commodities: Profiting from rising costsOne way to beat inflation is to own the stuff that's going up in price. Between 1973 and 1981, when inflation averaged 9%, the Goldman Sachs Commodity Index, which tracks oil, metals and food futures, averaged a 13% annual return. In just the past five years, commodity-driven mutual funds have gained an annual average of 30% vs. 10% for Standard & Poor's 500-stock index.But those sizzling performance runs are matched by long periods of lousy returns - during the '80s and '90s, for example, returns were flat. And today these assets are trading at or near historically high levels."There are signs of a speculative bubble," says Jeremy DeGroot, chief investment officer at Litman/Gregory in Orinda, Calif. It's difficult to time when such a bubble might burst, but anyone who buys commodities should be prepared for steep setbacks. In 1998, when markets were hit by the Asian currency crisis, natural-resources funds lost an aver