Protecting Your Portfolio from Inflation

Investors are being haunted by the threat of inflation, despite the fact that real inflation is nowhere to be seen.

The effects of inflation on an investor's portfolio are so pernicious that they can't be ignored. Even in the low-inflation environment, market pros are keeping close attention on Treasury Inflation-Protected Securities (TIPS), bonds guaranteed by the federal government to keep up with rising prices. TIPS are out of favor in the market, as most economists will tell you that inflation is the least of our concerns right now. With the economy mired in recession, falling prices—or deflation—pose more of a threat.

Gasoline prices are down 56% from last July, and consumers are still slashing spending, says Deutsche Bank (DB) economist Joseph LaVorgna. "The consumer pullback is clobbering inflation," he wrote Jan. 20.

Yet fears of an eventual return of inflation can't be dismissed. That's because governments are spending an unprecedented amount of money, while central banks are slashing interest rates, to spur economic growth. In effect, "We've thrown a lot of money into the system," says David Hinnenkamp, chief executive of KDV Wealth Management.

Governments may even add to that inflation threat. To combat deflation or pay off debt, "A lot of governments will be tempted to start printing money," says Michele Gambera, chief economist at Ibbotson Associates, a subsidiary of Morningstar (MORN). "This may cause inflationary pressure worldwide."

A Relatively Cheap Hedge
With so much extra money sloshing around, a strong recovery in the world economy could send inflation soaring again. That's why some experts are telling long-term investors to buy TIPS. Without protection, inflation can erode the buying power of investment portfolios. On paper, a conservative portfolio might tread water, staying at the same nominal value, but that's little comfort when the price of everything else—from housing to food and energy—is rising.

TIPS are relatively cheap, and may be necessary insurance for investors who can't risk a loss of buying power. "For the person who will retire in less than 10 years or who has already retired, it may make sense to allocate some to TIPS," Gambera says.

There is some evidence the appeal of TIPS is returning slightly. Tony Crescenzi of Miller Tabak notes that 10-year TIPS were priced on Jan. 23 for the consumer price index to rise 0.72% over the next decade. That's a small increase, but its the highest since Nov. 17 and 15 times the almost negligible inflation expectations of three months ago.

Deciding When to Jump In
The problem, though, is that conditions in the next few years could make TIPS very unattractive to investors. The value of TIPS is indexed to U.S. government inflation data, so low inflation makes TIPS less attractive compared to other assets. Also, while aggressive government spending and rate cuts are likely to prevent full-blown deflation, negative government price data, if it occurs, would be bad news for TIPS holders, who would see their bond yields shrink in response.

Marilyn Cohen, president of Envision Capital Management and writer of the Tax Advantaged Investor newsletter, says the inflation threat is "way down the road." She doesn't expect inflation to return in either 2009 or 2010. She believes investors should avoid TIPS for now, preferring safe short-term corporate bonds until signs of inflation actually appear on the horizon.

In other words, investors may be right to worry about inflation, but that doesn't mean it's time to dive in and buy TIPS or other inflation hedges right now. "The difficult part will be making a call on when that happens," Hinnenkamp says.

Less Volatile Than Commodities
Another inflation hedge traditionally favored by investors has been commodities like oil, gold, or other precious metals. But Gambera notes that in the past year these assets have had "very high volatility." Those wild swings make them less reliable for conservative investors. TIPS, because they are issued by the federal government, are more reassuring to investors trying to flee the market madness.

The essential appeal of TIPS remains that they are a government-backed refuge of last resort. If Cohen and others are right, TIPS may not make money for some time. But they provide insurance to skittish investors during uncertain times like these