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TIPS: The Perfect Hedge Against Inflation

A friend who sometimes solicits my advice on investing matters -- for anonymity's sake, we'll call him "Dad" -- often floats trial balloons my way about potential tweaks in his portfolio.

After checking his quarterly statement the other day, this friend said he was considering lightening up on the Vanguard TIPS fund I recommended, which happened to be the worst performer among the stock and bond funds he owns this past quarter.

"But Dad," I said, "If the stock market retrenches, you are going to love that TIPS fund because it offers a hedge against inflation as well as a great diversification tool against equities. In many down quarters, it will probably end up the best performer in your portfolio." I spared him my usual discourse on how excessive tinkering with one's portfolio based on short-term performance is one of the most damaging things an investor can do, and stuck with the following explanation of how TIPS work and why they serve the dual function of being a safe investment and a great portfolio diversifier.

How They Work

In January 1997, as the mutual fund industry was trudging out a slew of Internet funds to lure performance chasers, the U.S. Treasury offered investors one of the best financial tools since the dividend about 400 years ago: Treasury Inflation Protected Securities, or TIPS. Unlike traditional bonds, TIPS adjust their principal and interest payments over time in response to changes in inflation.

So let's say you purchased a TIPS with a fixed interest rate of 3% with a $1,000 face value. If the consumer price index, the key inflation gauge, rose 2.5% next year, the face value would increase to $1,025 -- and the interest payment would increase as well.

In essence, TIPS surmount the bane of a cautious fixed-income investor's existence: inflation. While deflation is on Federal Reserve Chairman Alan Greenspan's radar screen, it rarely occurs and remains unlikely now. (By the way, the Treasury Department built a safeguard against deflation into the system: The final payment to individuals cannot be less than the TIPS original face value.)

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