5 steps to inflation-proof your portfolio
Financial planners offer these simple steps to help protect your retirement savings.
NEW YORK (CNNMoney.com) - Inflation's become a much bigger concern for investors in recent weeks.
Their worries escalated after the government reported last week that its main inflation gauge, the Consumer Price Index, is rising at a 3.5 percent annual clip.
That hardly means the sky is falling. But experts said the report does signal that we may have to live with higher inflation for some time - a risk that investors would be foolish to ignore.
"Inflation is the biggest risk to someone's retirement planning and the most ignored," said Harold Evensky, chairman of Evensky & Katz, a wealth management firm. "It's too subtle and takes a long time for someone to realize it's bit you in the heinie."
When inflation appears, "stocks will fall in the short term," said Steven Kaye, CFP, President, American Economic Planning Group Inc, adding, however, that "in the long run they'll provide inflation protection."
Kaye suggests investing in companies that "make things people have to have" such as drugs, toothpaste or food, or in companies that make basic materials. Six sectors worth considering, according to Kaye, are consumer goods, consumer staples, banking, pharmaceuticals, the tech industry and telecoms.
Companies in these sectors often have the leeway to raise prices, which can boost profits. Among mutual funds, Kaye mentions PIMCO Real Return Commodities Fund (PCRIX) as one that holds a diversified portfolio of commodities.
Likewise, investors should avoid the stocks of companies whose products people can put off buying: cars, homes, appliances.
Bonds, TIPS and maturities
The effect of inflation on bonds is more immediate. Bond investors will sell at the merest hint of inflation since inflation erodes the value of their investments.
But not all bonds will be affected equally - the longer the term of the bond, the more volatile prices can be. That means those with maturities of, say, 10 years, will fall more than those with 2 years.
To protect themselves in the near term, investors should keep the average duration of bond holdings short, according to Kaye.
The first step is to assess your bond funds. Most bond funds come in short-, intermediate-, or long terms of 2, 5, and 15 years respectively. Bonds in the Vanguard Short-Term Bond Index Fund Investor Shares (VBISX), for example, have an average duration of 2.5 years.
"If someone sees 10- or 15-year bonds in their portfolio, I'd tell them to shorten (the average maturity)," said Kaye. This can be done by switching the bond funds they own.
Kaye warns that "while short rates could go up a little, long rates could go up a lot more."
There is one type of bond geared specifically to guard against inflation: Treasury Inflation Protected Securities, or TIPS.
TIPS give you a base interest rate (like a traditional Treasury bond) plus a year end credit based on the Consumer Price Index. So they adjust themselves for inflation every year.
"TIPS are a guaranteed real return over inflation," said Evensky. "Modest. But guaranteed." He said TIPS should be a permanent part of anyone's portfolio. Mutual funds that hold TIPS are available through most big mutual fund companies.
Two low-cost funds are Vanguard Inflation-Protected Securities Fund (VIPSX) and TIAA-CREF Inflation-Linked Bond (TCILX).
Investors can also buy TIPS directly from the Treasury at treasurydirect.gov. But financial planners caution that TIPS are complicated, so investors are probably better off buying them through mutual funds. Additionally, it's easier to automatically reinvest through mutual funds than by buying bonds directly.
How to play hard assets
Commodities such as oil, metals and other natural resources are another traditional inflation hedge.
"High inflation is associated with booming economies," Evensky said. That means demand is typically rising for commodities, lifting their prices to the benefit of those invested in them.
But investing in specific commodities can be too much of a concentrated bet for the average investor. In addition, many commodities have soared in price.
Gold, for example, has already shot above $700 this year, from $250 in 1999, though it's backed off to about $650 recently. "We find gold to be much too volatile and unpredictable," said Kaye.
As a result, Kaye suggests investors consider exchange traded funds, or ETFs, that hold a variety of commodities, particularly ones that track the Dow Jones AIG Commodity Index, which is invested only 35 percent to 40 percent in energy. One such fund is the Deutsche Bank Commodity Tracking Index (DBC).
In the May issue of MONEY Magazine, the editors also suggest the T. Rowe Price New Era (PRNEX) mutual fund as a good inflation hedge.
Making a few key adjustments now can help investors ride out these bumpy times and prevent cracks in their nest eggs.
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