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Course 406
How to Inflation-Protect Your Portfolio

Introduction

Inflation is one of the natural enemies of most investors. Think of it as compounding in reverse: What your investment returns give with one hand, inflation can take away with the other.

Compared to previous periods in history, inflation appears to be under control in the United States. Nevertheless, investors should consider the toll that inflation can take when building a portfolio.

There are several tools you can use to add some inflation-protection to a portfolio – especially to a portfolio that consists predominantly of fixed-rate investments.

Here are some options to choose from.

Treasury Inflation-Protected Securities (TIPS)

Treasury Inflation-Protected Securities, or TIPS, have been called the only asset class that's truly risk-free. The securities are backed by the full faith and credit of the U.S. government, so there's no credit risk. In addition, TIPS' principal values adjust to keep pace with inflation, which helps protect owners' purchasing power. That's a benefit holders of nominal Treasury bonds do not have. Assuming real yields are positive--and that hasn't always been the case--someone buying and holding a TIPS bond to maturity is guaranteed a positive real return.

TIPS bonds pay interest twice a year. In addition, TIPS bonds' principal values regularly adjust to reflect changes in the Consumer Price Index, both up or down. The net effect of that adjustment is that if inflation goes up, so do TIPS' principal values and in turn their yields. When inflation is falling, TIPS' principals are adjusted downward, taking yields down in the process. When a TIPS bond matures, the owner receives either the bond's original value or the value adjusted upward for inflation, whichever is greater.

Commodities

You might also consider a small slice of commodities in your portfolio--roughly 5%-6% at the high end. But if you're retired, be sure to dollar-cost average into a commodity investment rather than adding it all in one go, because mistiming a commodities investment can erode any long-term inflation-protection benefit you hoped to gain.

Before you layer on additional inflation protection in the form of commodities, however, see if you already have any quasi-inflation hedges in your portfolio. For example, emerging markets tend to be heavy on basic-material producers, and they in turn are beneficiaries of higher demand and prices; check your portfolio's exposure to Latin America and developing Asian markets.

Also look at your portfolio's stake in energy stocks. They're not the same as owning commodities directly, but they have a fairly high correlation with energy prices, and energy is a major component of most commodities indexes.

Stocks

Stocks are another, indirect way to gird your portfolio against the threat of inflation. They have the potential for higher returns than bonds, and inflation will take a smaller bite, in percentage terms, out of your future purchasing power. Owning companies with a demonstrated history of dividend growth is another way to help offset the effects of inflation on your portfolio.

Quiz 406
There is only one correct answer to each question.

1 Should you consider inflation when building a portfolio?
a. No, because inflation is dead in the United States
b. No, because inflation has no bearing on investing
c. Yes, because although inflation has been tame in recent history, it can take a toll on investment returns
2 Which inflation hedge is backed by the U.S. government?
a. TIPS
b. Commodities
c. Dividend-paying stocks
3 When a TIPS bond matures, what does the bondholder receive?
a. The bond's original value
b. The value adjusted upward for inflation
c. A or B, whichever is greater
4 Before you add commodities to your portfolio to hedge against inflation, what should you do?
a. Check your portfolio’s exposure to emerging markets
b. Check your portfolio’s exposure to energy stocks
c. Both A and B
5 Are stocks in general an indirect way to protect your portfolio from inflation?
a. Yes, because all stocks pay dividends, and dividends rise with inflation
b. Yes, because stocks have the potential for higher returns than bonds, and inflation will take a smaller bite, in percentage terms, out of your future purchasing power.
c. No, stocks do not provide any better inflation protection than fixed-rate bonds.
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