TIPS: The Perfect Hedge Against Inflation

TIPS Risk: Volatility. TIPS Reward: Diversity

While TIPS are often touted as the safest investment in the world because of their hedge against inflation, they are far more volatile than, say, short-term Treasuries because they are pegged to inflation. Individuals who want less volatility from their fixed-income assets would be better investing in short-term fixed-income offerings or municipal bonds, Swedroe said.

Indeed, the quarterly returns on the Vanguard Inflation-Protected Securities fund highlights how topsy-turvy returns can be. However, the worst quarterly performance since its June 2000 inception was a 1.1% loss.

Important point: Vanguard TIPS fund skipper John Hollyer cautions that the fund's 16.61% return in 2002 was an anomaly caused by a combination of interest rates on conventional Treasuries falling as expectations for future inflation remained the same. Given the fund's current yield of around 1.5% and inflation expectations of 2.25%, a more realistic expectation for annual returns would be about 3.75%.

Also, you can lose money in a TIPS fund -- in fact, Hollyer cautions that it may happen as the yield on interest rates climb. "If real yields go up you could get some price declines, [TIPS] can perform pretty poorly," Hollyer said.

There's one last point to make about TIPS, which is the big benefit I impressed upon my anonymous friend: TIPS are just about the best diversification tool in the world. Why? Because they are a perfect hedge against inflation, TIPS actually have a negative correlation to stocks -- to employ a cliche, they zig when stocks zag. When inflation rises, TIPS offer higher nominal returns, whereas stock and bond prices are likely to fall.

"If you're getting into it because it's a hot asset class, it's the wrong reason," said Vanguard's Hollyer. "If you're getting into it because it's a good portfolio diversifier for the next 10 years, that's a great reason."

TIPS Trip The Vanguard Inflation-Protected Securities fund shows returns can be volatile

Source: Vanguard

Indeed, in most quarters, a TIPS fund will lag behind stock funds. Although TIPS currently yield about half the 7% annual return stocks have averaged historically, they will outperform stocks about 25% of the time over 10-year periods, according to Jeremy Siegel, a Wharton professor and author of the outstanding Stocks for the Long Run.

"Government inflation-indexed bonds should be the asset of choice for investors who want to reduce their exposure to equities," Siegel advises in his book. Coming from one of the staunchest and most eloquent proponents of stock investing, that's no faint praise. If Dad -- rather, my friend -- doesn't heed my advice, he usually listens to Professor Siegel.