Can You Protect Your Portfolio from Inflation? Should You Try?

Dear Carrie: I’m 50 years old and have $350,000 in my 401(k) and $100,000 outside of my 401(k). I’m concerned about inflation eating away my cash. Where can I put some cash that will be less affected by inflation? A Reader

Dear Reader: You certainly aren’t alone; many people are concerned about inflation, especially because of the unprecedented levels of government stimulus-related spending. And you’re correct that inflation is not an investor’s best friend. But before you panic, don’t forget that our policy makers fully appreciate the damaging power of dramatic inflation. They also remember how difficult it is to reverse the course and as a result are fully prepared to take whatever preventive measures are necessary. Of course, others may disagree, but to my mind there is a low probability that we will experience runaway inflation.

Still, your question is a good one because the fact is that even relatively mild inflation has a significant effect over time. For example, if prices rise at an average of 3.5 percent per year for 20 years, nearly half of your money’s purchasing power will be eroded. Your investment returns have to match that rate just to keep your portfolio treading water; to build wealth, of course, you need to do better. So looking at your portfolio, how are the various asset classes likely to react to inflation?

Stocks. Long-term data show that stocks weather the effect of inflation better than cash or bonds. This is largely because companies with strong products can raise their prices or adjust their expenses to compensate. There is no question that inflation can have a negative impact on stocks, especially in the short term. And it’s also true that stocks are more volatile than bonds or cash investments. But when you look at long-term return data, stocks have shown themselves to be the best way to outpace inflation.

Bonds. Fixed income is the asset class where inflation has the biggest impact, for a couple of reasons. First, as interest rates rise (as is likely to happen if inflation gears up), bond prices decline. But even if you hold your bond to maturity, inflation can eat a big hole in your purchasing power. If the rate of inflation is greater than the yield on your bond, you literally won’t be keeping up with inflation. As an example, a long-term U.S. Treasury bond yields about 3.5 percent today. Imagine how you would feel if inflation was 4 percent over the next 30 years.

Cash investments. When it comes to cash investments and by cash investments, I mean money market funds and other highly liquid financial instruments inflation isn’t a huge concern.

In fact, cash is a decent inflation hedge because rates on cash-equivalent investments tend to move roughly in sync with inflation rates. If the underlying inflation rate goes up, so will the yields on many cash investments. You probably won’t beat inflation with your cash holdings, but you shouldn’t lose much ground either.

So what is an investor to do?

1. Depending on your risk tolerance and time horizon, keep a portion of your portfolio invested in stocks.

2. Stick with shorter maturity bonds as they are less affected by inflation and interest rate movements.

3. Consider buying TIPS (Treasury Inflation-Protected Securities) bonds, which are designed to track the Consumer Price Index. Like Treasuries, TIPS are issued with a fixed coupon interest rate. But unlike Treasuries, the principal is adjusted to reflect the inflation rate. TIPS can lose value when interest rates rise, but they should lose less value because of the inflation protection. One caveat: Any reset of principal due to inflation is treated as taxable income in the year it happens, even though you don’t actually receive any money at the time. As a result, TIPS are best suited to IRAs or other tax-advantaged accounts.

4. I-Bonds Series I Savings Bonds are another Treasury instrument designed to protect against inflation. I-Bonds are savings bonds with an inflation adjustment built in. You buy them discounted (they don’t pay interest; they accrue it until you redeem the bond, which makes them more suitable to taxable accounts than TIPS). In general, it’s best to buy I-Bonds when the fixed rate is high (right now, it’s very low).

5. Gold, commodities and real estate are often viewed as inflation hedges. Conventional wisdom holds that these assets tend to rise during inflationary periods; in fact, they were strong performers during the high inflation 1970s. But inflation takes many forms, and there’s no guarantee that future periods of inflation will lead to increasing values for gold, commodities or real estate.

The bottom line: Although you’re smart to be thinking about inflation, don’t lose sight of some very important basics. Are you saving enough? Is your asset allocation appropriate to your time horizon and goals? Are you well diversified within each asset class? Are you rebalancing your portfolio on at least an annual basis? By all means, keep an eye on inflation and investigate the tools I’ve mentioned. But my advice would be not to let the fear of inflation force you into decisions that might not make sense in the big picture.

Carrie Schwab-Pomerantz, CERTIFIED FINANCIAL PLANNER ™ is president of the Charles Schwab Foundation and author of It Pays to Talk. You can e-mail Carrie at askcarrie@schwab.com. This column is no substitute for an individualized recommendation, tax or personalized investment advice. To find out more about Carrie Schwab-Pomerantz and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.