By Kenneth Petersen Financial Planning

Posted: 06/09/11, 12:01 AM PDT |

Q: In your recent column about inflation, you mentioned that it helps to hold some equities in your investment portfolio to sustain purchasing power over time. What about gold and real estate? Don’t they also keep up with inflation?

A: Tangible assets such as gold and real estate might seem on the surface like good inflation-hedging bets. But it’s not that simple, because it depends on the price you pay.

If you purchased real estate in 2006, before the bubble broke, you would be hard-pressed to make a case that it will protect you from inflation, at least not for a long while. And if you bought gold in 1980 when it topped out at $850 per ounce in 1980 dollars, the equivalent of $2,251 in 2010 dollars, you would still be way behind.

No one knows if gold is overpriced today, but we do know that the price is high by historical standards and that people buy gold more because they fear a crisis than to protect themselves from inflation and that gold has not kept up with inflation in the past.

The best way to help your portfolio keep up with inflation is through diversifying with mutual funds or exchange-traded funds (ETFs) into different kinds of investments, including stocks, shorter-term bonds, commodities and natural resources, real estate and inflation-protected bonds.

The stocks in your portfolio should represent ownership in companies around the world, including companies in emerging countries with rapidly expanding economies like China, India, and Brazil.

During inflationary times, the costs that companies pay for raw materials rises. Companies will eventually raise their prices to maintain their profit margins which will raise revenues and eventually share price.

Shorter-term bonds have lower interest-rate risk, and when inflation occurs interest rates will eventually rise despite government efforts to suppress them.

When interest rates rise, longer-term bonds are worth less. There is no compelling reason to hold longer-term bonds unless you buy them to match a future liability and are prepared to hold them to maturity.

Not all investment advisers agree that you should maintain an exposure to commodities and natural resources as a separate category of investment in a portfolio, but there is evidence that supports the theory that because commodity prices have no correlation to stock prices, an exposure to commodities will lower a portfolio’s volatility and increase its rate of return over time.

As the world economy and population grow, there is more demand for food, staples, infrastructure and manufactured goods. Filling this demand drives up prices of commodities and natural resources.

Real estate prices in general do tend to keep up with inflation over long periods of time. They also don’t go up and down in lock-step with stock prices. You can own diversified real estate holdings in your investment portfolio through REIT mutual funds and ETFs.

There are a number of mutual funds and ETFs that will provide you with exposure to inflation-protected bonds. TIP is the stock exchange symbol for an ETF that holds U.S. Treasury Inflation-protected bonds. These bonds pay a nominal interest rate and increase in value with inflation. WIP is the symbol for an ETF that holds worldwide inflation-protected bonds from both developed and emerging-market countries.

Kenneth B. Petersen is an investment adviser and principal of Petersen & Ramistella, Inc. in Monterey. Send your questions concerning investing, retirement or estate planning to 2340 Garden Road, Suite 202, Monterey 93940 or Ken@priwm.com.