“Normal” inflation can play havoc with portfolio values and income over time. At 3% inflation, in 20 years you would need double the income from your portfolio to maintain the same standard of living!

Presently, inflation is not a huge problem. It has been running at a 1 to 2% rate which is considered the ‘sweet spot’ by the Federal Reserve.  However, in the light of all the monetary stimulus and government spending in attempts to resolve our deep recession, higher inflation is a likely threat in time. An August 2009 editorial in the NY Times by Warren Buffet stated that the uncontrolled dumping of money into the US economy will “certainly cause the purchasing power of the currency to melt”—in other words, cause inflation.

Protecting the principal value of your portfolio should be the goal of every retiree and income investor. Stocks are designed to protect your portfolio’s principal value and as a result “purchasing power”.  Bonds and cash provide income and liquidity respectively but do not generally do well in maintaining purchasing power. 

Ibbotson Associates published a chart showing the compounded annual rate of return during the years 1925-2004 for stocks, bonds and T-bills at an inflation rate of 3%. After inflation and taxes, stocks returned 4.8%, bonds .6%, and T-bills -.9% annually during this time period.

So it is extremely important to properly configure your portfolio for both growth in value (e.g., stocks) as well as income (e.g., bonds) to keep up. Also, it is important that income withdrawals be adjusted to only the total portfolio returns above inflation. Without those adjustments, purchasing power is not likely to be well maintained over time. 

High Inflation Predicted by Many

It has been about 30 years since there was a high inflationary period. In 1979, the Fed really ramped up short term interest rates to battle high inflation. The result was economic activity fell and the major asset classes—real estate, stocks and bonds plummeted in value as did gold—although gold dropped to a lesser degree.  The Fed is expected at some point to raise short term interest rates again, likely next year, with the degree and magnitude of increase(s) dependent upon the economy and perceived risk of inflation.

So, what can the retiree do to protect his/her portfolio in the near future from a potentially high inflationary period beyond maintaining a traditional portfolio of stocks and bonds?

Many concerned investors have been looking for insurance in the form of inflation protection investments such as TIPs, commodities, and precious metals.  Today, these and other specialized asset types are easily purchased cost effectively through a wide variety of mutual funds and exchange traded funds (ETFs).  

Treasury Inflation-Protected Securities (TIPs) are a neat way to fight inflation. The principle value of your investment is increased along with the inflation rate. But being geared to fight inflation, returns are relatively benign with low inflation such as we have right now. With higher inflation, you get relatively more return.  Commodities and precious metals could also be considered with plenty of mutual funds and ETFs making it easy to add to your portfolio.  As commodities and precious metals are both volatile, it is probably best to keep them to a small percentage of your portfolio such as 5 or 6 %.

One caution: a Wall Street Journal article (Oct 5, 2009) addressed a number of these inflation hedges. The article emphasized that these investments have not been around long. TIPs were established in the late 90’s and many commodity and gold funds even more recently. As a result, these inflation hedges have not been tested during a significant inflationary period. As a result, there is no guarantee that they will perform as expected.  So it is probably best not to go overboard with these investments before they have proven themselves.

Check your portfolio before adding these inflation hedges because your fund managers may have already added some.  In any event, limit these specialized assets to a small percentage of your total portfolio asset allocation while keeping most of your portfolio in stocks, bonds, and cash.  Also, avoid buying when there is a mad rush into these inflation hedges. It is best to buy before the “stampede” to get better value. Otherwise dollar cost average over time into these fund(s).

Generally, real estate and Real Estate Investment Trust (REIT) funds have performed well in inflationary times and have had a relatively low correlation with the stock market thus providing good diversification. However, we are living in unusual times and there are no guarantees as to when real estate as well as the economy will recover and exactly what form it will all be.  If you do not presently have a real estate/REIT fund, establishing a small position (maybe 5%) makes some sense as real estate will eventually make a comeback—possibly bigger than many expect right now—and it is a good long term holding.

Bottom Line:

• Always purchase assets for sound investment purposes in your portfolio
• Maintain a diversified portfolio of global stocks, bonds, and cash as your core investments to meet your basic life’s growth and income needs.
• Limit your portfolio income withdrawals to only portfolio returns above inflation to maintain purchasing power
• Consider adding a smaller portion of alternative investments such as TIPs, commodities, and/or precious metals to help maintain purchasing power especially during significant inflationary periods.  
• As always, seek investments that are undervalued and likely to go up in value for your core portfolio. Stocks, bonds, and real estate/REITs have a long history of long term growth bias.
• Generally this has not been the case for commodities and precious metals. Volatility and unpredictability have been more their history. Time will tell how these new promising inflation fighting funds and others including TIPs perform in the next high inflationary period.