How to Protect Your Portfolio From Inflation (+2K Views)

One of the biggest threats to your portfolio’s performance over time is inflation. For every additional point of inflation, your portfolio will lose about 20% of its purchasing power over the next 25 years. In addition, taxes are levied on your portfolio’s nominal return, even if it does not experience a real increase in purchasing power. All combined, you can easily lose a third or more of the value of your portfolio over time with just a tiny bit of extra inflation.

The comments above & below are edited ([ ]) and abridged (…) excerpts from the original article by Kent Smetters (IgnoreTheMarket.com)

Inflation: Financial Death by a Thousand Cuts
Moreover, unlike jarring market crashes — such as the Great Depression or the recent crisis — inflation lurks in the shadows. It destroys value by gradually eroding real returns over time. It is financial death by a thousand cuts. Investors too often look at “the numbers” in their portfolio without asking what those numbers can actually buy over time. It’s a classic mistake that John Maynard Keynes termed “money illusion.”

There are two good reasons to now start paying close attention to inflation again:

1. The expansion of the Federal Reserve’s money supply…has been enormous and unprecedented and, as Milton Friedman most clearly articulated decades ago, more money chasing the same number of goods usually generates higher prices. In fact, had the recent monetary explosion happened during “normal” times, prices would have likely doubled.

2. Projected federal deficits are ballooning out of control… Astonishingly, the market has even recently priced some corporate bonds as safer than government securities. Eventually, it will be too tempting to reduce the value of this snowballing debt simply by printing more money.

Investing for the Short and Long Run of Inflation
To be sure, recent core inflation numbers (that exclude volatile food and energy) have been well below expectations and, given the severity of the economic slump, many experts believe that low inflation will continue for a while. For investors, however, the current debate over the inflation outlook is incomplete and misleading. Diversified investors hold many types of assets and some of these investments are more sensitive to inflation over the short run while some are more sensitive over the long run. As such, both time horizons should matter to investors…

Longer-run inflation (beyond five years) should be on everyone’s radar screen. In fact, it is unlikely that the current yields on 30-year Treasury securities will be enough to cover inflation over time, much less provide a real return. Present value shortfalls in Social Security and Medicare are in excess of $70 trillion and will likely lead to an “inflation tax.” Yields on 10-year Treasury securities — which policymakers try to keep low because of their indirect relationship to mortgages — may not be high enough to cover inflation.

What is an Investor to do About Inflation?
The traditional choice is to invest in commodities, metals, oil and the like. The broadest investible measure of commodities is almost 85% correlated with the Consumer Price Index (CPI) on an annual basis, meaning that the value of commodities tends to move in the same direction as inflation. Gold is almost 60% correlated, oil stands at 21%, and real estate and natural gas are both at 5%. However, contrary to conventional wisdom, none of these asset classes are actually good inflation hedges anymore. They are already too popular.

Don’t be fooled by correlation either. Two data series can appear to be highly correlated even though one of them consistently underperforms the other. In fact, commodities are about the only major asset class that actually underperforms the CPI over time. More targeted sector plays — such as gold, oil and natural gas — tend to beat the CPI, but not by nearly enough to compensate for their enormous risks (they are about twice as risky as the S&P 500). In fact, corporate bonds and equities actually appear to do a better job of “keeping up” with the CPI over time on a risk-adjusted basis, despite their low mathematical correlation.

Here are a few specific investment recommendations, starting with the lowest hanging fruit:

1. Increase your exposure to Treasury Inflation Protected Securities (TIPS) inside of your tax advantaged retirement accounts.

Put a quarter or more of your retirement stash into TIPS. While TIPS are not tax efficient enough for taxable accounts, they provide a good inflation hedge for retirement accounts where taxes are either deferred or already paid.

2. For your taxable accounts, buy $10,000 per year in Treasury I Bonds.

Like TIPS, I Bonds provide solid protection against inflation. Unlike TIPS, you are not taxed on “phantom income” along the way. Because I Bonds are such a “win-win”, the government caps the amount that you can purchase each year to $5,000 in paper form and $5,000 in electronic form. So do both.

3. Invest up to 15% of your portfolio in emerging market equities.

To be sure, many of these markets have already experienced large gains recently but they still offer a “twofer” of sorts:
a) a hedge against U.S. currency depreciation
b) diversification into countries that still have strong growth prospects.

4. Move some of your lower yield government bond portfolio toward Ginnie Mae centric mutual funds.

Ginnie Mae’s are the only mortgage-backed securities carrying the full faith and credit of the federal government. They usually provide a yield between one half a percent and one percent greater than comparable maturities.

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