Worried About Inflation? Stay Diversified

Although many, including Federal Reserve Chairman Ben Bernanke, dismiss current inflation worries, a number of economic signs indicate soaring prices could lurk on the horizon. For instance, the sell-off in long-term bonds beginning in March has resulted in rising yields that often signal inflation. Additionally, the dollar is trading near its lowest level of the year against the euro. In recent weeks the price of gold (which often spikes when investors worrying about inflation embrace the tangible asset as an inflation hedge) has surged to nearly $1,000 per ounce.

In the simplest terms, inflation generally results from too much money chasing too few goods. While the U.S. Treasury is printing money at an unprecedented rate to keep our banking system and credit markets afloat, thus far, an increased demand for goods hasn’t followed. Just as banks are hanging onto their extra reserves, consumers are watching their wallets.

Accordingly, because these are not ordinary times, we should not expect a textbook case of raging inflation to occur. In my view, the current economic data likely heralds a period of relatively moderate inflation. However, it’s crucial to recognize that even seemingly insignificant inflationary pressures can erode your purchasing power over time, especially if you are living on a fixed income in retirement. For instance, the current rate of inflation, four percent, doesn’t seem like much of a threat. Yet, after nine years of four percent inflation, your $100,000 retirement income would be worth just $70,000. After 17 years, your purchasing power would be cut almost in half. And, after 30 years, not an outrageously long retirement period given increasing longevity, your buying power would be reduced by about 70 percent.

How might these percentages impact your lifestyle? Let’s flashback 50 years. In 1959, a postage stamp cost four cents, bread was 20 cents a loaf and gas cost 30 cents a gallon. You could buy a new car for $2,200, the average home price was $18,500 and the minimum wage was $1.00 per hour.

Keep in mind, too, that while those 1959 prices seem stunningly low compared to today’s price tags, over the last 50 years we have not experienced ongoing runaway inflation. For example, according to InflationData.com, the average inflation for each decade was as follows: 1950 to 1959: 2.05 percent; 1960 to 1969: 2.36 percent; 1970 to 1979: 7.09 percent; 1980 to 1989: 5.55 percent; and 1990 to 1999: 3.00 percent. Clearly, the cumulative loss of purchasing power if inflation persisted above four percent would be problematic.

Today, fear has many investors loading up on commodities, like gold, whose prices generally rise as the value of paper money falls. Yet, the relatively high volatility of these tangible assets is a major reason they fail as a solitary inflation hedge.

Step one in managing your exposure to inflation risk is to stay on the shorter duration end of Treasury securities, particularly as our national deficit and supply of Treasury bonds increase. An additional possibility is building a bond ladder whose average maturity is on the short-term side.  As one bond matures, it is replaced with another bond on end of the ladder.

Treasury Inflation Protected Securities (TIPS) are also likely to be superior to commodity futures as inflation hedges. While conventional Treasury bonds offer fixed semi-annual interest payments and a fixed principal payment at maturity, TIPS’ principal values are linked to the Consumer Price Index (CPI) and adjusted every six months to reflect the effects of inflation. If the CPI inches up 2.5% over the course of the year, the principal value of a TIPS bond is adjusted upward by 2.5% and the fixed rate of interest is applied to the inflation-adjusted principal.

Of course, remaining diversified with exposure to stocks is also crucial to protecting your purchasing power. While rising inflation can hurt profits in the short-term, because companies eventually can increase costs for consumers, inflation often has a neutral effect on stocks. In fact, historically corporate profits have outpaced inflation.

Finally, ongoing planning strategies could help insulate you from inflation. For example, you can protect yourself against skyrocketing long-term care costs by purchasing long-term-care insurance with an inflation-protection option. For college funding, prepaid tuition plans or payment plans specific to your child’s college or university could help you to lock in your tuition rate and protect yourself from increases that often outpace inflation. And, in retirement years when inflation is high, you could consider withdrawing less from your portfolio.
Because the market’s ultimate recovery could deal a swift blow to your purchasing power for goods and services, inflation protection is particularly important today. In the end, however, the best way to stay ahead of inflation is not to seek absolutes by chasing yield or seeking guarantees, but to focus on your overall portfolio, remain diversified, and continue to plan ahead.

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