Simple Ways to Inflation-Protect Your Portfolio

Direct and indirect ways to hedge against higher prices.

Christine Benz 23.03.2010
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Question: I'm retired and concerned about inflation. What's the most straightforward way to inflation-protect my portfolio?

Answer: I received several questions along these lines after my recent web seminar. It's easy to see why retirees are concerned, because inflation is a big drag on anyone who's living on a fixed income. Whereas working people may receive salary hikes to compensate them for cost-of-living increases, most seniors are drawing upon their portfolios for at least a portion of their income, and rising prices erode the purchasing power of their withdrawals.

In the near term, inflation appears to be under control in the United States. Amid generally falling prices over the past year, some economists have even brought up the prospect of deflation, though few have entertained it seriously. Instead, inflation appears to be a more likely long-term threat, thanks to the confluence of massive amounts of fiscal stimulus and growth in emerging markets. For that reason, I think it makes sense to bolster any portfolio that consists predominantly of fixed-rate investments with a dose of inflation protection.

I've written about TIPS on several occasions, and to my mind, they're the most cost-effective and efficient inflation protection you can buy. This article provides some guidelines for how much retirees should stake in TIPS, while this one addresses how to know whether TIPS are a good buy or expensive. (My colleague Eric Jacobson also wrote a helpful article on the effects of rising rates on TIPS, a concern that should be top of mind for everyone today.)

You might also consider a small slice of commodities in your portfolio--roughly 5%-6% at the high end, per this guidance from Morningstar's Lifetime Allocation Indexes, powered by asset allocation specialist Ibbotson Associates. 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, 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. (Morningstar's free Instant X-Ray tool is a good way to investigate your portfolio's geographic exposure.)

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 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. My colleague Josh Peters' newsletter, Morningstar DividendInvestor, focuses on such firms, as do mutual funds like Vanguard Dividend Growth and the ETF Vanguard Dividend Appreciation.

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About Author

Christine Benz  Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

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