Inflation-Proof Your Portfolio

After nearly two decades of slow, sleepy rises in prices, the very idea of accelerating inflation may come as somewhat of a jolt for investors. Even now, inflation sounds like a relic of the '70s. But in fact it's already sneaked in at the gas pump and in power bills in many states, in the guise of an energy shortage.

While it's still an open question whether full-fledged economic inflation could return to the fore, you can prepare yourself for the possibility by making some small changes to your portfolio. This may not be a bad time to give your portfolio a quick once-over to make sure it's diversified enough -- and we're not just talking about stocks and bonds.

Financial planners often divide portfolios into three big categories: stocks, bonds and an "other" group of investments that usually includes assets like real estate, stock in REITS and commodities. When inflation hits, stocks and bonds get slammed especially hard.

Inflation hurts stocks by undercutting the value of future earnings, because by the time earnings occur, inflation will have reduced their value. Consequently, stock performance, which is based on these earnings, drops significantly, although stocks still post better returns than bonds and cash (see chart below). Bonds get hit even worse. Inflation pushes bond prices down, because people want higher yields to compensate for inflationary effects. And because bonds have lower returns than stocks in the first place, inflation will eat up their gains even faster.

Throughout much of the '70s and '80s, as inflation raged, the return on bonds trailed cash.

The Wages of Inflation Returns for different asset classes, 1942 to present
When inflation rate is:	S&P 500 Total Return GPA*	LT Bonds Total Return GPA	Cash (T-Bills) GPA	% of Time
Above 4.5%	8.7	4.8	6.2	34.2
Between 2.5% and 4.5%	11.0	9.4	5.1	32.1
2.5% and Below	19.1	2.9	2.8	33.7
Buy/Hold**	12.9	5.6	4.7	100.0
*GPA means gain per annum, or the compound annualized gain of the asset class during periods when inflation is in the range indicated. **Buy/hold means the compound annual gain for the entire date range shown. Source: Ned Davis Research.

So assuming you were worried about inflation, you wouldn't exactly be giddy about the prospects for bonds, and you probably wouldn't be too enthused about most stocks, either. What does that leave to like? Well, the standard advice in inflationary times has usually been to make sure you own either tangible things -- like real estate -- or companies that traffic in tangible things, like mining outfits, oil and gas producers or REITS (real estate investment trusts).

An article appearing in Forbes as far back as 1934 gave this basic advice, saying that "one of the best protections against inflation is the ownership of commodity or metal stocks, since they represent actual goods whose value in dollars increases as the value of the dollar decreases." The magazine suggested buying stock in companies like Alaska Juneau Gold Mining, U.S. Rubber and International Nickel. But these days you're not likely to see many people lining up to buy commodities, given their price volatility and tendency to absolutely tank in periods that aren't inflationary (which has been most of the time).

Psst, Here's a Hot TIP

The good news is that investors today have a far better option in the form of a security designed specifically to hold up during periods of inflation -- namely TIPS, or Treasury Inflation-Protection Securities, which debuted in 1997. TIPS have twofold appeal: First, they're indexed to the inflation rate, as measured by monthly changes in the Consumer Price Index for urban consumers. That means when inflation goes up, they're required to pay out more. "TIPs have a contractual inflation component," says Stephen Barnes, a certified financial planner in Phoenix, Ariz. "That's not there on gold or commodities, but in a TIPS, it is a guarantee."

The second advantage of owning TIPS is that their performance doesn't correlate closely with that of other asset classes. Although they're often called bonds for convenience, financial planners don't consider them in the same category as conventional bonds for purposes of asset allocation. "We feel very strongly that it's an entirely separate asset class," says Barnes. "It's not a bond, it's not a stock."

Here's why: Although TIPS are issued by the U.S. government, they operate on a different principle than Treasury bonds. While traditional bonds carry fixed nominal coupon rates, the coupon payments for TIPS are fixed in real (inflation-adjusted) terms at the time of issuance. Over the life of the bond, nominal interest payments are adjusted based on the actual inflation rate. The par value of TIPS is adjusted in a similar manner, so the investor receives the principal, fully adjusted for inflation, upon maturity of the bond.

Consider the following example: Assume that a 10-year inflation-indexed bond is issued with a par value of $10,000 and guarantees a real yield of 3% per year. Suppose that the inflation rate is 5% in the first year. The face value of the bond will rise to $10,500 and the coupon payment would be $315 (3% of $10,500). "If deflation occurs, the principal and the coupon payment will be adjusted down based on the falling CPI-U. However, if deflation reduces the principal below par, the investor will still receive the par value at maturity," explains a report from Ibbotson Associates. The Treasury Department isn't worried about having to make up the difference, because it doesn't expect a lengthy drop in consumer prices to occur (the Treasury is considering discontinuing the issuance of TIPS, though).

Pretty sweet deal, right? If inflation takes off, investments in TIPS are guaranteed to gain more than the overall rise in prices. But the downside comes in the way of opportunity cost, because in noninflationary periods, TIPS lag Treasuries. In a hypothetical back-test over a 28-year period, Ibbotson researchers found that 10-year TIPS would have posted a real return of only 3.43%, vs. 4.72% for 10-year Treasury bonds.

"TIPS haven't performed well compared to bonds because [bond] yields have dropped as inflation has dropped. As yields drop, prices go up," explains Roger Ibbotson, chair of Ibbotson Associates and a professor at the Yale School of Management. "So historically bonds have outperformed in a dropping inflationary environment. In a rising inflationary environment, TIPS will outperform bonds."

Not-So-Great in the Long Term Return of TIPS vs. Treasuries, 1970-1998
Investment Instrument	Nominal Return %	Real Return %
TIPS (Synthetic 10-Year)	8.84	3.43
S&P 500	14.68	9.24
10-Year Treasury Bond	9.98	4.72
30-Day Treasury Bill	6.8	1.52
Inflation	5.26	--
Source: Ibbotson Associates.

Right now, TIPS offer coupon rates in the range of 3.5% to 4.25%, plus adjustments according to the inflation rate. As of yesterday, the most recent 10-year TIPS, issued in January, were yielding 4.6%, considerably less than a 10-year Treasury, at 5.46%.

If inflation stays in the low single digits (last year it averaged 3.4%), TIPS don't look too exciting. But if we were to see a significant spike in inflation, the contractual return would start to look a lot sexier. "You'll see price appreciation, whereas bonds will actually have depreciation in a rising inflationary environment," says Ibbotson.

Of course, given TIPS' relatively low returns, nobody's suggesting you race out and dump lots of money into them. But in small amounts, they make sense as both an inflation hedge and a diversifying component in your portfolio. Barnes, the financial planner, says he's begun buying TIPS for the roughly 10% of his clients' portfolios that falls into the "other" category, distinct from stock and bond allocations.

"We've only recently been building exposure to TIPS," Barnes says. "That's largely because we continue to believe we're in a disinflationary period. But we're getting to the point where the opportunity cost to add that kind of hedge is much lower than it was two or three years ago." As an inflation hedge, he says, TIPS are appropriate for almost any portfolio.

Other market-watchers would allow for much higher allocations. "If you really are conservative, then I don't see anything wrong with putting your whole bond/cash portfolio in TIPS," says Ibbotson. But investors should remember that TIPS aren't a hedge against all kinds of inflation -- just against inflation represented by the CPI, he adds. For example, it wouldn't be a good idea to dump money earmarked for a college education into TIPS, since inflation in college tuition tends to outpace inflation in the CPI. "TIPS aren't a perfect hedge against specific types of inflation, just against a very general type," says Ibbotson.

Basically, while there's really no way to inflation-proof your portfolio, at least TIPS let you squeeze out some gains at a time when most other investments are apt to be suffering. Because they're subject to the federal income tax (though they are exempt from state and local taxes), financial planners recommend that investors in high tax brackets keep TIPS in nontaxable accounts. For example, the New Jersey-based investment firm of Bugen Stuart Korn & Cordaro suggests investors in a 28% or higher tax bracket not use TIPS in a taxable account.

Investors can buy TIPS through the Treasury Department(click here for more information) or through brokers for a minimum $1,000 investment.