Find your target return, to stay ahead of the rising cost of living.

By Bob Frick, August 2008

Prices are rising at an annualized rate of 3.9%, compared with a long-term average of 3.4%. If you’re investing in a tax-advantaged account, such as an IRA or 401(k) plan, that means you need to earn 3.9% simply to keep up. Most people who invest in a taxable account will have to earn more than 5% to stay ahead.

Stocks, both U.S. and foreign, should be an important component of a portfolio that aims to whip inflation. Over the long term, U.S. stocks have returned more than 10% annualized. Even if stocks return only 8% a year over the next decade, as some downbeat analysts are forecasting, they should still provide a decent after-inflation return.

Traditional inflation hedges, especially residential real estate and gold, aren’t particularly enticing now. Home prices are in a tailspin, and gold’s Midas touch seems spent after a strong run.

But gold isn’t the only commodity that rises with inflation. Strong global demand is also forcing up prices for such things as timber, grain, iron and, of course, oil (see You Can Still Cash In on Black Gold’s Relentless Rise, on page 41). A cheap way to get a broad sampling of commodities is with investments that follow commodity benchmarks, such as the Dow JonesÐAIG Commodity index; it covers everything from soybeans and cotton to gold and nickel.

A direct play on the index is iPath Dow Jones-AIG Commodity Index Total Return ETN (symbol DJP). This exchange-traded note promises to pay the index’s return, minus an annual fee of 0.75%. Over the past year to June 9, the ETN returned 32%. Note that an ETN is essentially a bond, meaning that shareholders could be at risk if the sponsor were to go bankrupt.

You can also buy the index — and then some — through Pimco CommodityRealReturn Strategy (PCRDX), a member of the Kiplinger 25. The fund uses a small amount of its cash to buy derivatives that track the index, then actively invests the remainder in a portfolio of Treasury inflation-protected securities (TIPS). The fund’s D shares returned 18% annualized over the past five years and 47% over the past year. The D shares, available without a sales fee through many discount brokers, charges annual expenses of 1.24

Advisers say commodity investing often requires a leap of faith. But placing a modest amount of money in commodities — say, 5% to 10% of your nest egg — doesn’t just add inflation protection. Because commodities move independently from the stock market, they also help dampen the ups and downs of a portfolio. Says Diane Pearson, of Legend Financial Advisors, in Pittsburgh: A truly diversified portfolio will weather almost any storm. It has to include things other than U.S. stocks and bonds.

Inflation-linked bonds. Other investments designed to beat inflation have become victims of their own success. In mid June, the real yield of ten-year TIPS was just 1.4%, which means you’re treading water if you’re paying taxes on TIPS income (in general, it’s better to hold TIPS in tax-deferred accounts).

But at current yields, should you even bother with TIPS now? Yes, says Dan Shackelford, manager of T. Rowe Price Inflation Protected Bond (PRIPX). You have to forget about the historical compensation, he says. Think of TIPS as insurance. With TIPS, both the principal value of the bond and the coupon rate rise based on the inflation numbers. So if inflation accelerates, TIPS will increase in value. Over the past year, Shackelford’s fund gained a strong 14%. Over the past five years, it returned 5% annualized. Another Treasury product, the iBond, is currently the worst deal in its history, says Dan Pederson, author of Savings Bonds: When to Hold, When to Fold, and Everything In-Between. IBonds provide a payment equal to the inflation rate plus a premium that at one point was as high as 3.6 percentage points. The latest iBond issue pegs inflation over the past six months at 4.84% but, for the first time, offers no premium.

If you can tolerate some credit risk, you’ll find a better deal in inflation-linked corporate bonds. Tom Ricketts, chief executive of Incapital, a Chicago investment bank that markets such bonds, says their popularity is rising with concern over inflation. In mid June, Incapital offered a senior unsecured note from JPMorgan Chase that paid 1.5 times the 12-month change in the consumer price index. The note is sold in denominations of $1,000 and matures in June 2015, when, assuming nothing catastrophic has happened to JPMorgan Chase, you get back your principal.