Financial Planning

How to Inflation-Proof Your Portfolio

Find your target return, to stay ahead of the rising cost of living.

Higher inflation means investments have to earn more just to break even. But fight the urge to turn your portfolio upside down. We're not seeing a return to the double-digit inflation rates of the 1970s. Plus, some investments designed to keep ahead of inflation aren't the sweet deals they appear to be. What you need is a portfolio review, and maybe a tuneup, to keep inflation at bay.

Prices are rising at an annualized rate of 3.9%, compared with a long-term average of 3.4%. If you're investing in a tax-advantaged account, such as an IRA or 401(k) plan, that means you need to earn 3.9% simply to keep up. Most people who invest in a taxable account will have to earn more than 5% to stay ahead.

Keeping Up With Inflation

The table below shows the taxable return you would need to earn in order to keep up with 4% inflation after factoring in your tax bracket. You have to earn even more to overcome the drag of state taxes.
Tax BracketTaxable Return
25%5.3%
28%5.6%
33%6.0%

Stocks, both U.S. and foreign, should be an important component of a portfolio that aims to whip inflation. Over the long term, U.S. stocks have returned more than 10% annualized. Even if stocks return only 8% a year over the next decade, as some downbeat analysts are forecasting, they should still provide a decent after-inflation return.

Traditional inflation hedges, especially residential real estate and gold, aren't particularly enticing now. Home prices are in a tailspin, and gold's Midas touch seems spent after a strong run.

But gold isn't the only commodity that rises with inflation. Strong global demand is also forcing up prices for such things as timber, grain, iron and, of course, oil (see "You Can Still Cash In on Black Gold's Relentless Rise," on page 41). A cheap way to get a broad sampling of commodities is with investments that follow commodity benchmarks, such as the Dow JonesÐAIG Commodity index; it covers everything from soybeans and cotton to gold and nickel.

A direct play on the index is iPath Dow Jones-AIG Commodity Index Total Return ETN (symbol DJP). This exchange-traded note promises to pay the index's return, minus an annual fee of 0.75%. Over the past year to June 9, the ETN returned 32%. Note that an ETN is essentially a bond, meaning that shareholders could be at risk if the sponsor were to go bankrupt.

You can also buy the index -- and then some -- through Pimco CommodityRealReturn Strategy (PCRDX), a member of the Kiplinger 25. The fund uses a small amount of its cash to buy derivatives that track the index, then actively invests the remainder in a portfolio of Treasury inflation-protected securities (TIPS). The fund's D shares returned 18% annualized over the past five years and 47% over the past year. The D shares, available without a sales fee through many discount brokers, charges annual expenses of 1.24

Advisers say commodity investing often requires a leap of faith. But placing a modest amount of money in commodities -- say, 5% to 10% of your nest egg -- doesn't just add inflation protection. Because commodities move independently from the stock market, they also help dampen the ups and downs of a portfolio. Says Diane Pearson, of Legend Financial Advisors, in Pittsburgh: "A truly diversified portfolio will weather almost any storm. It has to include things other than U.S. stocks and bonds."

Inflation-linked bonds. Other investments designed to beat inflation have become victims of their own success. In mid June, the real yield of ten-year TIPS was just 1.4%, which means you're treading water if you're paying taxes on TIPS income (in general, it's better to hold TIPS in tax-deferred accounts).

But at current yields, should you even bother with TIPS now? Yes, says Dan Shackelford, manager of T. Rowe Price Inflation Protected Bond (PRIPX). "You have to forget about the historical compensation," he says. "Think of TIPS as insurance." With TIPS, both the principal value of the bond and the coupon rate rise based on the inflation numbers. So if inflation accelerates, TIPS will increase in value. Over the past year, Shackelford's fund gained a strong 14%. Over the past five years, it returned 5% annualized.Another Treasury product, the iBond, is currently "the worst deal in its history," says Dan Pederson, author of Savings Bonds: When to Hold, When to Fold, and Everything In-Between. IBonds provide a payment equal to the inflation rate plus a premium that at one point was as high as 3.6 percentage points. The latest iBond issue pegs inflation over the past six months at 4.84% but, for the first time, offers no premium.

If you can tolerate some credit risk, you'll find a better deal in inflation-linked corporate bonds. Tom Ricketts, chief executive of Incapital, a Chicago investment bank that markets such bonds, says their popularity is rising with concern over inflation. In mid June, Incapital offered a senior unsecured note from JPMorgan Chase that paid 1.5 times the 12-month change in the consumer price index. The note is sold in denominations of $1,000 and matures in June 2015, when, assuming nothing catastrophic has happened to JPMorgan Chase, you get back your principal.

Most Popular

Retirement Income Shouldn’t Depend on the Market; It Should Depend on Math
retirement planning

Retirement Income Shouldn’t Depend on the Market; It Should Depend on Math

The math isn’t as tough as you might think. It all starts with dividing your assets into three different buckets.
May 23, 2022
Your Guide to Roth Conversions
Special Report
Tax Breaks

Your Guide to Roth Conversions

A Kiplinger Special Report
February 25, 2021
Why Are Gas Prices Still Going Up?
spending

Why Are Gas Prices Still Going Up?

The cost of a gallon of gas is heading back toward its March highs. What’s driving the resurgence, and will gas prices go down anytime soon?
May 23, 2022

Recommended

Is Securities-Based Lending a Good Idea?
investing

Is Securities-Based Lending a Good Idea?

Securities-based lending may be a quick way to lay your hands on some cash, but you should be aware of the potential for risk.
May 25, 2022
This Couple Tackles Love and Money as a Team
Getting Married

This Couple Tackles Love and Money as a Team

Fyooz Financial, the husband and wife team of Dan and Natalie Slagle, have carved out a niche advising other couples with the money questions that com…
May 24, 2022
Buying Annuities in Your 401(k)
Financial Planning

Buying Annuities in Your 401(k)

More plans are offering annuities that could provide income in retirement. Here’s what you need to know.
May 24, 2022
Buy Value Stocks, Says J.P. Morgan’s David Kelly
Markets

Buy Value Stocks, Says J.P. Morgan’s David Kelly

This investing strategist says to use valuation as your guide for stock investing opportunities in the balance of 2022. Plus, bonds are looking better…
May 23, 2022