Inflation: 4 ways to protect your assets

No matter how bad it gets, the same investing rules always apply: don't put all your nest eggs in one basket.

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By Penelope Wang, Money Magazine senior writer

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(Money Magazine) -- How bad is inflation for your portfolio? Let us count the ways.

As consumer prices rise, the Federal Reserve and the issuers of bonds hike up interest rates. That brings down the value of the bonds you already own. Your stocks' earnings start to look less attractive compared with the latest bond yields, which puts downward pressure on share prices.

What's more, the inflation-fighting Fed may push the economy - and corporate profits - into a slowdown. So when inflation pops up, every investor who can read the news starts looking for protection.

That's what's happening now. Investors have already flocked to investments whose main selling point is their inflation protection, and that has pushed up their prices. "Many of the best inflation hedges look overvalued," says Ross Levin, a financial adviser in Edina, Minn.

So instead of piling into pure hedges like inflation-protected bonds and commodities, treat them like an insurance policy, buying just enough to protect yourself in case prices get out of hand. That insurance will be only one part of a portfolio designed to grow no matter what the CPI does.

In short, you still need stocks - especially companies with the power to pass on higher prices. How you should blend the hedges in your portfolio depends on how close you are to retirement. But first take a look at how each inflation fighter works and the best ways to buy.

1. Tips: The (low-return) sure thing

Treasury Inflation-Protected Securities, or TIPS, are the one guaranteed hedge against rising prices. With TIPS, your principal is adjusted upward every six months to keep pace with the consumer price index. The bonds carry a fixed coupon rate lower than that of Treasuries of similar maturity. But the dollar amount of the payment increases as your principal value is adjusted upward.

Say you buy $10,000 of five-year inflation-protected bonds at today's 1% rate - that's $100 in yearly income. If inflation rises 3% in the first year, your principal will increase to $10,300, and now your 1% payment will total $103.

Investors snapped up the supersafe bonds when the credit crunch hit, pushing down yields. At 1%, today's five-year TIPS yield is 2.2 percentage points below the 3.2% rate for a conventional Treasury. In other words, at this price, inflation has to top 2.2% a year over five years for TIPS to beat other Treasuries. Four years ago inflation needed to top only 1.5% for TIPS to be the winning bet.

"Now may not be the time to put a lot of new money into TIPS," says Ken Volpert, head of fixed-income investing at Vanguard. Still, 2.2%-plus inflation is hardly implausible, so if you're in or near retirement, you may want to devote about 15% of your portfolio to these bonds.

How to invest If you don't already hold a stake in TIPS, move in gradually now. You can buy them from the U.S. Treasury or through a fund such as Vanguard Inflation-Protected Securities. TIPS are best held in a tax-deferred account, such as a 401(k), since otherwise you will owe taxes on the inflation adjustment.

2. Commodities: Profiting from rising costs

One way to beat inflation is to own the stuff that's going up in price. Between 1973 and 1981, when inflation averaged 9%, the Goldman Sachs Commodity Index, which tracks oil, metals and food futures, averaged a 13% annual return. In just the past five years, commodity-driven mutual funds have gained an annual average of 30% vs. 10% for Standard & Poor's 500-stock index.

But those sizzling performance runs are matched by long periods of lousy returns - during the '80s and '90s, for example, returns were flat. And today these assets are trading at or near historically high levels.

"There are signs of a speculative bubble," says Jeremy DeGroot, chief investment officer at Litman/Gregory in Orinda, Calif. It's difficult to time when such a bubble might burst, but anyone who buys commodities should be prepared for steep setbacks. In 1998, when markets were hit by the Asian currency crisis, natural-resources funds lost an average of 25%.

Still, by gradually building up a 5% stake in commodities, you can lower your overall portfolio risk, says Lou Stanasolovich, a financial adviser in Pittsburgh. That's because commodities move out of sync with stocks, smoothing out your returns.

How to invest The best approach is to buy funds that hold shares in energy companies and other stocks that benefit from inflation, such as T. Rowe Price New Era. You can also consider an ETF such as iShares S&P North American Natural Resources (IGE), which tracks an index of commodity-producing firms.

3. Real estate funds: The long-run bet

Yes, this one is a pretty counterintuitive play at the moment. Real estate earned its reputation as an inflation hedge in the 1970s, when home values and commercial property climbed along with food and energy. But these days everyone knows that real estate is the one thing that isn't going up.

So how can there still be a case for REIT (real estate investment trust) funds? The first thing to keep in mind is that REITs own commercial property and apartment buildings, not houses. Landlords should have some power to raise rents along with inflation.

Second, unlike TIPS and commodities, REITs look like a bargain now. Yields on the benchmark index of REITs climbed to 5% recently, after hitting a low of 3% early last year. Says Chris Cordaro, a financial adviser in Chatham, N.J.: "REITs may have further downturns, but at a 5% yield, you're being paid to hang on."

And like commodities, REITs have the diversification advantage of moving out of step with stocks. For the long term, it's reasonable to keep less than 10% of your portfolio in REITs.

How to invest The low-cost way to hold real estate is through the Vanguard REIT Index, which will track the U.S. REIT market at an annual cost of just 0.20%. For additional diversification, Third Avenue Real Estate Value mixes foreign real estate into its portfolio.

4. Blue-chip stocks: Where the growth is

As noted earlier, equities typically take a hit when rates rise. But that's usually just a short-term wobble. Over time, equities remain your best way of earning inflation-beating returns. Since World War II, the S&P 500 has returned an annual average of 11.4%, more than seven percentage points above the CPI.

"Stocks can eventually pass rising costs on to consumers, making inflation a wash for stock market returns," says Chris Davis, an analyst at Morningstar. "And when you add in price appreciation and dividend growth, you have real potential to build wealth."

Right now the best equity values can be found among large-cap stocks. "Blue chips are best able to withstand an inflationary environment because they have strong pricing power and plenty of cash," says Davis. U.S. large-caps should be 20% to about 40% of your portfolio.

How to invest The easy call is Vanguard 500 Index, which tracks the S&P 500, or an ETF equivalent, iShares S&P 500 (IVV). Two Money 70 funds, Jensen and FMI Large Cap, hold concentrated portfolios of blue chips.

Putting it all together

When it comes to inflation, timing matters. The longer your time horizon, the less you need to rely on inflation fighters like TIPS, commodities and REITs. Use the pie charts above and to the right as a guide for wherever you are in life.

"When you're just starting out, inflation is less of a concern," says Tom Idzorek, director of research at Ibbotson Associates. "You can expect your salary to increase over the years, and you will be adding to your savings."

But as you draw closer to retirement, your portfolio will have less time to recover from the effects of inflation, and your income isn't likely to increase much. So you'll want to gradually boost your allocation to those assets that fight inflation most directly.

Investors in their thirties and forties might devote 11% of their overall portfolio to TIPS, commodities and REITs combined, according to an analysis by Ibbotson. For retirees, that allocation would rise to about 28%. But over the long run, it's still going to be the faster growth of stocks that keeps you ahead of the game.

Are you prepared for a financial emergency?

With a recession and rising inflation, it's more crucial than ever to have a six to 12-month living-expense cushion in cash for an emergency. Don't have it? Drop us a line at makeover@moneymail.com. Include your name, age, city, state, marital status, occupation, how much you have in cash savings and retirement savings. Please send a photo of you (and your spouse, where applicable) too.  To top of page

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