Two years ago, when the Federal Reserve announced that it would engage in its third round of bond buying (“Quantitative Easing") to spur economic growth and help reduce unemployment, fears of runaway inflation bubbled up. As a reminder, inflation occurs when the prices of goods and services rise and as a result, every dollar you spend in the economy purchases less. Despite the Fed’s actions, headline inflation (CPI), which includes everything you care about, is up about two percent year over year, but that doesn't mean that there will never be inflation again. Even central bank officials expect prices to rise over time, so if inflation is coming, what should you do? Hopefully wages will start to increase to account for the extra money that you are shelling out. As an investor, especially a retired investor who relies on portfolio income to supplement Social Security, you can be more proactive. While there is no perfect inflation hedge, the following five assets are those that are most frequently used to protect portfolios:
1. Commodities: When inflation rises, the price of commodities like gold, energy, food and raw materials also increases. Many investors therefore turn to investments in these assets for protection, but as a former commodities trader, I must warn that this is a volatile asset class that can also stagnate or worse, lose money, over long stretches of time. Therefore, investors would be wise to limit commodity exposure to 3 - 6 percent of the total portfolio value.
2. Real estate investment trusts (“REITs”): The ultimate “real asset”, REITs tend to perform well during inflationary periods, due to rising property values and rents. The nation’s housing bubble cured most of us of the notion that one “can’t lose with real estate,” because as we know, real estate prices can stay depressed for a long period of time.
3. Stocks: Many investors don’t think about stocks as an asset class to combat inflation, but the long-term data show that stocks, especially dividend-producing stocks, tend to perform well in inflationary periods. That said, during short-term inflationary spikes, stocks can plunge quickly before reverting to the longer-term trend.
4. Treasury Inflation Protected Securities (“TIPS”): Bonds are susceptible to inflation, because rising prices can diminish a bond’s fixed-income return. But the US government issues inflation-indexed bonds, or TIPS, which proved a fixed interest rate above the rate of inflation, as measured by the CPI. If inflation rises, payments rise, but TIPS provide little return above the inflation rate.
5. International Bonds: One of the dangers of inflation is that it destroys the value of the U.S. dollar. As a result, there is an argument to allocate a portion of a bond portfolio to a small percentage of international bonds, which are denominated in a foreign currency. This is another one of those asset classes that tends to be volatile.
While inflation may be looming, it’s important to underscore that a diversified portfolio, which takes into account your time horizon and risk tolerance, will go a long way towards providing protection.