But you can safeguard your portfolio

The deep recession that began two years ago has kept a tight lid on the prices of many goods and services. But that doesn’t mean that the danger of rising inflation has been snuffed out for the long term.

As the economy recovers, I expect inflation to rise as well. While the initial increase may be gradual, once the economy begins to pick up steam, it may not be long before inflation is well above the relatively tame 2% to 3% levels typical in the past decade.

High inflation is painful for most people but especially painful for those who plan to retire soon or who already are retired and living on fixed incomes. Although some inflation is good for many companies because it means that they can raise prices, very high inflation hurts stocks because it becomes much more expensive for companies to borrow money and to pay rising raw material and labor costs. It hurts bond investors because as interest rates rise, old bonds that pay less lose value.

Certain investments act as a hedge against inflation because their value tends to rise at a pace equal to, or greater than, inflation. If inflation remains tame, the broad market will do very well and the inflation hedges you add won’t be too much of a drag on your returns. If, on the other hand, inflation gets out of control and the stock and bond markets tumble as a result, the hedges will help offset some of the damage. Among the best inflation hedges…

COMMODITIES

Commodities include raw materials such as crops, metals (including gold), timber and oil. They perform well in a growing economy with lots of inflation for three reasons…

  • US inflation generally coincides with a falling US dollar, which boosts commodity prices on world markets.
  • Economic growth means greater demand for raw materials, which boosts their prices, especially because it takes a long time to ratchet up production.
  • Demand for commodities is rising rapidly in emerging markets as they develop their infrastructure and middle-class consumers emerge.
  • How much you need: For conservative and moderately aggressive investors, up to 20% of the stock portion of your holdings, although commodity investments can be volatile at times. For aggressive investors, 30% or more of your stock allocation.

    Reason: If you can withstand more volatility, investing in commodities makes sense not just as an inflation hedge but also as a way to bet on a sector that is likely to outperform the broad market averages over the next few decades. Investment options…

  • iShares S&P North American Natural Resources Sector Index Fund (IGE), an exchange-traded fund (ETF) that gives you exposure to various sectors of the oil and gas industry, as well as to metals and mining companies.
  • Recent share price: $33.74.

  • US Global Investors Global Resources Fund (PSPFX). If you prefer an actively managed fund over an ETF, this one provides broad diversification among commodity subsectors.
  • Annualized performance for the five years through October 31, 2009: 10.7%. 800-873-8637, www.usfunds.com.

    TIPS

    Treasury Inflation-Protected Securities (TIPS) are long-term IOUs issued and backed by the federal government. They start out with a fixed annual interest rate, like other Treasury securities. In addition, the government adjusts the amount of principal based on the Consumer Price Index (CPI), although you are guaranteed to receive at least the original value of your investment at maturity even if the CPI has dropped.

    Currently, a standard 10-year Treasury yields 3.5%… while 10-year TIPS yield 1.4%. If you can make do with the lower yield now, you can buy more protection against inflation through a larger investment in TIPS.

    How much you need: For conservative to moderately aggressive investors, 30% or more of the bond allocation of your portfolio. For aggressive investors, TIPS should represent no more than 30% of your bond allocation.

    Invest in TIPS directly instead of through a mutual fund or ETF because that way you’re guaranteed to get your principal back at maturity. (The value of a fund investment can drop.) TIPS are sold with five-, 10- and 20-year maturities. Purchase minimum is $100.

    Consider creating a “ladder” of TIPS, including TIPS with five- and 10-year maturities, as well as previously issued TIPS with three- and seven-year maturities that you can buy in the secondary market. TIPS are best for tax-deferred or tax-exempt accounts, such as IRAs, because TIPS in taxable accounts are taxed on the increased principal each year. Buy them yourself without a fee at www.treasurydirect.gov.

    REITS TOO RISKY RIGHT NOW

    Real Estate Investment Trusts (REITs) own properties and trade like stocks. While real estate normally is a good inflation hedge, this is not a good time to bet on a strong real estate recovery. Commercial real estate prices are likely to decline further before rising again. Therefore, I have no allocation to this asset class now. However, within a few years, the residential and commercial properties owned by REITs likely will start to go up in value — and REITS provide hefty dividends.

    When the real estate market returns to normal, you can invest in a diversified ETF, such as the iShares Dow Jones US Real Estate Index Fund (IYR). It has stakes in 75 of the largest commercial REITs.

    Recent share price: $41.05.

    Yield: 5.5%.

    I also would keep an eye on the closed-end mutual fund Alpine Global Premier Properties (AWP) because it gives exposure to areas of the world where real estate will recover more quickly than in the US, such as Asia and Latin America.

    Recent share price: $5.98.

    Yield: 7.5%.

    SAVINGS BOND ALTERNATIVE

    One other way to help cushion your nest egg against inflation is Series I US Savings Bonds. They can be bought for as little as $25 each through www.treasurydirect.gov. But these inflation-adjusted bonds have drawbacks.

    The bonds have both a fixed annual rate, which recently was set at just 0.3% for bonds sold between November 1, 2009, and April 30, 2010… and an inflation component (which is adjusted twice a year) that is set at an annual rate of 3.06% for those six months. That adds up to 3.36% — not a bad rate.

    If inflation does rise — and all the factors are in place for that to happen — these bonds can be attractive, but if inflation remains tame, the fixed-rate, in effect over the 30-year life of the bonds, doesn’t give you much.

    Starting in the 2010 tax season, you can buy Series I bonds with your tax refund by using IRS Form 8888.

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