By John Wasik
CHICAGO Oct 19 While inflation has been tame in
recent years, there are few forecasters who believe it will
remain so in the future.
But when inflation bites again is a moot question.
Predictions of its imminent return have been wrong for years.
The key is having portfolio protection in place now so that it
won't devastate your fixed-income holdings and reduce your
future quality of life.
Because even having been forewarned, it's not so easy to
protect your portfolio against inflation, which will erode your
purchasing power over time. The difficulty is that there's no
perfect hedge against it. Treasury Inflation-Protected
Securities (TIPS), are the natural choice, but they are linked
to the flawed Consumer Price Index (CPI).
Commodity funds and gold are worthy considerations, although
they have their shortcomings as well. Keep in mind that
commodities and gold have their own cycles based on supply,
demand and other factors, so past returns may not be reliable
indicators of what the future holds. There's a reason why
commodities are so volatile.
A blended portfolio that employs a number of inflation
beaters is the best approach. Just be careful to balance it
according to the amount of risk you can stomach.
TIPS gain in value when inflation is rising, but are an
imperfect gauge of prices. In a disclaimer published with every
CPI report, the government states "the CPI is a statistical
estimate that is subject to sampling error because it is based
upon a sample of retail prices and not the complete universe of
The CPI comes up short, for example, in tracking housing
prices, which are partially measured through "owner-equivalent
rents." And it's not a complete measure of the broad spectrum of
commodity prices, which can be better tracked -- although
imperfectly -- through commodity funds.
No matter how you measure inflation, it's clear that it can
impair your purchasing power and depress bond prices. What's
more important is whether you are able to keep up with the rise
in the cost of living.
The latest CPI report from the U.S. Bureau of Labor
Statistics showed a 2 percent annual increase in September.
While that number was mostly driven by higher energy prices
(gasoline, fuel oil), it was rising at the fastest pace since
April. The more telling figure is inflation-adjusted hourly
earnings, which fell 0.3 percent from August to September. Wages
aren't keeping up with inflation and this has been a problem for
years. Fortunately, there's something you can do to bolster your
In deciding upon an inflation hedge for your portfolio, you
have to weigh the risk-return trade-off. I asked Prof. Craig
Israelsen, a finance professor at Brigham Young University, to
generate four different portfolio allocations that illustrate
the risk-return scenario:
1. Replacing bonds with TIPS - Let's say you are concerned
that inflation is coming back and also astutely concerned that
your bonds will lose value. You want to keep it simple, so you
have a 60 percent stocks, 40 percent TIPS allocation. Your
3-year annualized return through Sept. 30 would be about 12
percent and nearly 8 percent over a decade. That's about two
percentage points better than a standard 60-40 mix of stocks and
bonds. The volatility, as measured by three-year standard
deviation, would be a relatively low 9 percent.
2. Replacing bonds with metals - With the same stock
percentage, you invest 40 percent in a precious metals fund
instead of bonds. Your 10-year return rises to 11.4 percent
while your three-year performance drops to nearly 10 percent.
Volatility, however, more than doubles to about 20 percent.
3. Reduce stocks to 50 percent - Keep bonds at 30 percent
with 20 percent in precious metals. Your three-year volatility
drops to just under 13 percent with three- and five-year returns
just under 10 percent.
4. Half stocks, 30 percent bonds, 20 percent commodities -
Your three-year return rises to just over 10 percent, while over
the decade you gain 8.5 percent. Volatility, though, drops about
two percentage points over the previous portfolio.
As you can see, it is easy to capitalize on the "anxiety
premium" that metals pay and capture some of the global demand
that commodities funds track. But these strategies come at a
price in terms of higher volatility and higher fund expenses.
How do you construct these portfolios? The simplest way is
through low-cost mutual and exchange-traded funds.
The iShares Barclays TIPS Bond ETF tracks an index
of U.S. inflation-adjusted bonds. Stocks can be represented by
the SPDR S&P 500 ETF. A worthy bond ETF is the SPDR
Barclays Capital Aggregate Bond fund. Metals are tracked
by the Vanguard Precious Metals and Mining Fund ;
commodities by the PowerShares DB Commodity Index Tracking fund
While TIPS are an imprecise, though less-volatile, tracker
of the cost of living, they move in the opposite direction of
stocks. If you lean towards conservative investing, TIPS may be
a better fit than metals or commodities, although it's not a bad
idea to incorporate some metals and commodities to cover a
broader range of inflation threats.