How to Protect Your Portfolio From Inflation
All long-term investors share a common interest: protecting their savings from the ravages of inflation.
Inflation has been relatively dormant in recent years. Over the 12 months that ended in March, for example, the consumer price index rose by a modest 2.7%, government statisticians say. The core CPI (consumer price index minus volatile energy and food) rose 2.3% over the same time period. But even tepid rates of inflation gradually erode the purchasing power of savings. Let's say a 40-year-old deposited $1,000 in her IRA on April 17. If she retires at age 65, her $1,000 investment will be worth $603 if inflation averages 2% -- a 40% drop in value.
Many economists worry that inflation will rise well above 2% once the economy gains steam. The fear is that quantitative easing and other extraordinary actions taken by the Federal Reserve in recent years will result in sharply inflationary pressures. "When you start to grow again, people instantly worry more about the potential for inflation," says James W. Paulsen, chief investment strategist for Wells Capital Management.
What's the best way to hedge against the risk of higher inflation rates? There's no simple answer, despite the fact that currency depreciation and its repercussions have a long, infamous history -- from the 3rd-century Roman Empire to 1970s U.S. When it comes to inflation protection, a degree of uncertainty is inherent because there are many factors to take into account -- the time horizon, for example. When inflation surged after World War II, the best-performing investments were commodities and the worst were bonds (over the 12 to 18 months following the war), according to Alexander P. Attie and Shaun K. Roache, economists at the International Monetary Fund and authors of Inflation Hedging for Long-Term Investors. In the long run, however, bond returns started to outperform inflation, thanks to higher yields and more stable prices, and commodities declined. (It's important to remember that the short term can seem awfully long. The Dow Jones industrial average peaked in October 2007 and took 17 months to reach a bottom, down 52%. To investors, that stretch seemed like an eternity.)
Another factor to consider is that inflation in the U.S. has a tendency to surge only to settle back down, a pattern that is likely to continue. Federal Reserve Board members have made it clear in speeches and congressional testimony that a reprise of the inflationary 1970s is not acceptable. The timing and effectiveness of monetary tightening may be uncertain; the goal of containing inflation isn't.
No matter your investment strategy, the market price of an asset is critical. For example, gold is a traditional hedge against the depreciation of paper money. The thing is, gold prices have soared to more than five times their level in 1999, from $300 an ounce to about $1,650. Gold is almost as expensive relative to stocks and bonds as it was during the height of inflation in the late '70s and early '80s, a period when stocks and bonds had been badly beaten down. It's hard to see much upside in gold absent an inflationary apocalypse.
Still, a number of investment options look intriguing. The most attractive at the moment seem to be housing and equities. The better inflation hedges appear to be cash, commodities and, more controversially, inflation-indexed securities.
A home has been a dreadful investment. Average prices nationwide are down by about a third since the housing-market bubble burst in 2006. Nevertheless, a home is an asset that typically maintains its value when the overall price level increases. The inflation protection largely goes to homeowners with fixed-rate mortgages, who aren't affected when inflation pushes rates higher. Better yet, many new and existing homeowners can lock in historically low mortgage rates.
The track record of equities is mixed when it comes to inflation, although the case gets stronger the longer the investment period. Stock values typically plummet when inflation rears its head. Fundamental values win over the long haul (a time horizon of five years or more). "The underlying corporations have real assets, employ real people and sometimes even make real things, although a good idea embedded in a small thing [like an iPad] or a service is just as good," says Jeremy Grantham, chief investment strategist at GMO, a legendary value investor. "Equities have been tested over and over again in different places and in different decades, and they have always been found to be very effective hedges."
Cash is a partial inflation hedge. Although cash -- typically U.S. Treasury bills and other high-quality short-term investments -- lags inflation when prices surge, its track record shows modest positive real returns with time. The real advantage of cash is its simplicity and the relatively low cost of holding it. The savings will be there when inflation abates and new investment opportunities open up. Treasury bills are the "only investment that can be counted on for liquidity under the most chaotic economic conditions," Warren Buffett, the investing Oracle of Omaha, states in his latest shareholder letter.
How about Treasury inflation-protected securities, better known as TIPS? These inflation-indexed securities offer a fixed interest rate above inflation, as measured by the consumer price index. TIPS are controversial right now because the government in March sold $13 billion of ten-year TIPS at a record-low negative yield. In other words, investor demand was so strong that the yield on TIPS was less than zero! The five-year TIPS also have sold at negative yields. It's bad enough pocketing less than 1% on safe savings -- but below 0%? Still, TIPS are designed to protect investors against a rise in the consumer price index. The negative yield is essentially an "insurance premium" for the protection from inflation. The higher the inflation rate ends up, the more valuable the TIPS -- and vice versa.
There is a measure of short-term financial safety in a broadly diversified basket of commodities. The long-term bull market in commodities has stumbled recently over concerns about global growth, especially with signs that China's growth rate may be slowing. Nevertheless, a broad-based index, such as exchange-traded fund PowerShares DB Commodity Index Tracking (symbol DBC), offers a measure of protection.
The timing is murky, but it's a prudent bet to anticipate a resurgence in inflation. The best protection for long-term investors is to maintain a well-diversified, high-quality portfolio and an asset allocation that reflects your time horizon and risk capacity. You can then purchase additional layers of inflation protection by tilting the portfolio toward one or several investments that have a track record of holding their own against the ravages of inflation. Keep the strategy simple.