What mix of investments could provide some growth and a dose of income, as well as protect against inflation?
By John F. Wasik | 01-13-11 | 06:00 AM | Email Article

All that glitters is not gold. At least when it comes to hard assets.

Lately this has been a preoccupation of mine as I fine-tune and rebalance my 401(k). Although there's a lot of noise about gold hitting the $1,400 mark (and sliding back), the real concern for me is how to protect against inflation risk. Gold may not be the answer.

John F. Wasik is a freelance columnist for Morningstar.com and author of 14 books, including "Keynes's Way to Wealth: Timeless Lessons from the Great Economist."

The fact that gold might be in bubble territory--and headed for a huge decline--is the least of my concerns. I learned my lesson in the tech bubble to ignore the hottest trends and not to bulk up in the steroidal stocks of manic times.

That's not to say I don't think inflation will be a problem in the future. Except during recessions and depressions, inflation never really goes away--averaging about 3% annually over time. No one knows, however, when our current deflationary deleveraging will end. Foreclosures were still pushing 100,000 a month as I wrote this. That crisis may have a few more years to run before the market absorbs the 19 million homes on the market.

But inflation will come back. It is always a problem when any government is more interested in printing money than creating jobs. It will take a lot of paper to cover our national debt of more than $14 trillion, and even a modest rebound won't make it go away.

The real problem for me--or anyone taking a deep look at their retirement portfolio--is how to protect against the ravages of inflation while taking advantage of global growth. Far too many investors focus on the investment du jour and forget that many other asset classes are worthwhile and should be added to diversify one's holdings.

So I asked myself, "What mix of investments could provide some growth and a dose of income and also protect against inflation?" This is what I determined:

Real Estate
Well, not single-family homes, or at least not those in many U.S. metropolitan areas. Think international. Think commercial. Two low-cost diversified choices come to mind: Vanguard Global ex-US Real Estate Index Fund  and the  Vanguard REIT Index ETF .

These are difficult to buy on your own, so exchange-traded funds are the way to go. I would just avoid the most popular, single-commodity funds (such as  SPDR Gold Shares  ) to be safe. It's better to bet on a mixture of metals, agricultural goods, and energy. I like a broader play because it can combine some inflation protection with exposure to overseas growth. Developing countries need everything from aluminum to zinc and will bid up prices to get access to them. Two top choices include  PowerShares DB Commodity Index Tracking , which follows a basket of commodities, and the  iShares S&P GSCI Commodity Indexed Trust ETF . Experts can make robust academic arguments on which is linked to the better commodity index; either one is a good entry-level way to participate in this asset class.

Treasury Inflation-Protected Securities
You can either buy these Treasury bonds (indexed to the Consumer Price Index) directly from the government, through brokers, or in the more convenient form of I-bonds, which are packaged like savings bonds. Although their yields are paltry now, they will reward you when inflation returns.  Vanguard Inflation-Protected Securities  is also a good package for these bonds.

Hybrid Funds
Since I'm always concerned about inflation, Treasury Inflation-Protected Securities are never far from my mind. But it's important to remember that TIPS adjust their principal value with inflation (as measured by the CPI), not with rising interest rates. Most bonds will drop in value as interest rates rise (though you can avoid realizing a loss by holding high-quality individual bonds to maturity). And though rising rates will accompany inflation, the two don't always happen in unison. That's why diversifying your inflation protection can be important.  PIMCO Commodity Real Return Strategy  combines TIPS with futures contracts on commodities, so you get the best of both worlds. This fund has been a buy-and-hold staple in my IRA for years.

Since I'm a believer in Modern Portfolio Theory, it makes sense to avoid making big bets in any one of these funds. Remember, these need to be integrated with your holdings of stocks and bonds in a way that is appropriate for your age, portfolio makeup, and ability to take risk. They all move up and down with global trends, expose you to market risk, and by themselves don't represent a complete solution to your portfolio needs.

When added to your portfolio, though, something useful should happen. You will be able to buffer the hit to your bonds when rates rise while participating in global growth, which will continue no matter how volatile the U.S. markets become.

John F. Wasik is a Morningstar columnist and author of 13 books, including The Cul-de-Sac Syndrome: Turning Around the Unsustainable American Dream. The views expressed in this article do not necessarily reflect the views of Morningstar.com.

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