Inflation protection

NEW YORK (Money) -- Inflation is the risk that investors most often underestimate. Rising living costs erode the purchasing power of your savings. Inflation can also push up interest rates, which depresses the market value of both stocks and bonds.

But smart stock and fund picks will help protect you.

Gauging the risks is simple arithmetic. Annual inflation above 3 percent can easily cut the value of your savings in half over the course of your retirement.

Moreover, when annual inflation climbs above the 3 percent mark, price/earnings ratios for a typical blue-chip stock can fall from 16 or 17 to 13 or 14. And if higher inflation pushes up interest rates, almost all bonds will suffer.

Fortunately, there are ways to protect yourself against the long-term erosive effects of inflation. One is simply to prepare for rising prices by reinvesting some of your annual income instead of spending it all. That's one of the reasons retirees should count on spending only 4 percent to 5 percent of their assets each year.

It's also possible to protect the value of your long-term investments by including stocks and funds that actually benefit from inflation. The difficulty is that far more investments are hurt by inflation than profit from it.

Basically, companies that depend on some form of natural resources or other tangible assets are most likely to be inflation beneficiaries. The difficulty for investors today is that two of the stock sectors that usually benefit - oil and real estate - have had big runups over the past few years. As a result, those shares are vulnerable to a pullback.

What inflation hedges does that leave for someone investing money today? One good general choice is T. Rowe Price's New Era Fund (PRNEX (Charts), which holds a broad array of inflation beneficiaries, from gold-mining shares to oil producers.

When it comes to selecting specific stocks, look for undervalued shares of commodities producers. Don't worry too much if they seem untimely - inflation is low right now. And what you really want is insurance against an upsurge.

One stock that I like is Alcoa (Charts), the world's leading producer of aluminum. Long-term earnings growth is projected at 11 percent annually, even though results for the current year may be flat. Alcoa also yields 1.8 percent. That means the stock's total-return potential is higher than that of the typical blue chip. Not many commodities producers can match that.

Analysts are sharply divided over the 2007 outlook for the company. The 2006 fourth-quarter earnings report beat analysts' expectations. In fact, annual revenues and income from continuing operations both reached record levels. Many analysts think that Alcoa could go on to another record this year. Some forecasters, however, caution that aluminum prices could dip.

Predicting short-term swings in commodities prices is a hopeless task, so there's no way of knowing how Alcoa will perform over the rest of the year. But even if you use the pessimists' earnings forecasts for 2007, the shares are currently trading at less than 12 times earnings. That's awfully cheap for such a first-class stock.

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