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Makin' Money

Protecting your portfolio from inflation

Chris Farrell May 18, 2012

Inflation is tame.

Yet even low rates of inflation eventually erode the purchasing power of savings. For instance, if a 40-year-old deposits $1,000 in her IRA and retires at Age 65, her $1,000 investment will be worth $603 if inflation averages 2 percent — a 40 percent drop in value.

What’s the best way to hedge against the risk of higher inflation rates? You would think we would know, considering how much we worry about inflation. But in this Kiplinger article, I argue there is no simple answer or formula: 

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.)  

A number of investment opportunities appear attractive at the moment, especially housing and equities. The better inflation hedges seem to be cash, commodities, andinflation-indexed securities. 

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.

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