Inflation Risks

Hello MNoriega,

First, I’d like to caution against trying to predict the future. Using words like 'only', 'will result' and 'predict' lead to over confidence. Prediction is extremely difficult especially when it is about the future. Additionally, we should consider the cost of being wrong with our predictions. What happens if we base our portfolio construction for a high inflationary environment but inflation remains tame and the markets continue to go up? Typically these types of tactical moves only hurt the probability of success rather than improve our situation. For that reason, individuals that are investing should build a long-term portfolio based on the appropriate asset allocation and diversification. Now investment gurus trying to make a name by making the one perfect call have a very different point of view. They are betting with someone else’s money and there is essentially no cost to them to guess. So if they predict hyper-inflation and it doesn't happen, they just move on to new clients and try again.

To specifically answer the question: What investments would effectively hedge against rampant inflation in the US similar to Brazil and Argentina in the 1990's?’ You could do what the Brazilians and Argentineans did, invest in off-shore accounts and foreign direct real-estate holdings. But unless you are in the Ultra-Wealthy category, you will likely get fried trying to implement such a move so I wouldn’t recommend such a strategy. Realistically your best alternative would be to increase your allocation to International Stocks, International Bonds, TIPS, Short-Term Bonds, REITS and Commodities in the capital markets. Assuming you would remain employed and can afford the payments, you also may want to consider borrowing long-term fixed US dollars and purchasing direct real-estate.

But as I started out, I wouldn’t recommend you tilt your portfolio or your net-worth based on any predictions. The cost of being wrong is too high and you really don’t need to take that risk.

Some pundits are saying that you need to own gold to protect yourself from inflation. Yet gold has historically not been a very good inflation hedge. Gold prices have already risen dramatically mainly as a knee-jerk reaction to the financial crises last year. If you are concerned about inflation, a better hedge may very well be to own Treasury Inflation-Protected Securities (TIPS).

Those who owned bonds in 1994-1995 remember what it was like when interest rates started rising and bond prices fell. While that is not likely to happen overnight today, given the slow pace of the economic recovery and very low inflation, it is good to be prepared.

Bond prices fluctuate with interest rates. Interest rates react to the outlook for inflation. If the outlook projects rising inflation, the real purchasing power of bond interest payments falls and bonds paying a fixed interest rate become less valuable. If inflation is decreasing, the opposite is true—real purchasing power goes with bond prices.

The latter is the case today, with inflation benign and bond yields approaching record lows. The collapse of the equity markets from highs in October 2007 has encouraged risk-adverse investors to buy bonds . . . lots of them. And they have been rewarded with rising principal value in their bond holdings as interest rates and inflation continue to fall.

But that scenario could change once our economy gets back on track. TIPS are also called “anti-bonds,” because the original principle (face value) is adjusted with changes in inflation rates. The Treasury then pays interest on the adjusted face value of the bond, ensuring a gradually rising stream of interest payments (assuming inflation continues). At maturity, TIPS investors will receive the original face value plus the sum of all the inflation adjustments since the bonds were issued.

As a result, TIPS offer a true hedge against inflation. The real purchasing power of the interest payment moves higher to account changes in inflation. A traditional bond, on the other hand, provides a “nominal return.” It maintains a fixed face value until maturity, with no adjustments for inflation. For example, if you receive a 4% interest payment from a bond and inflation is 1.5%; your real return is 2.5%.

TIPS were first issued by the U.S. Treasury in 1997. However, other nations, including the United Kingdom, Canada, Sweden, Australia and New Zealand, have been issuing inflation-protected bonds for a number of years.

A good example of a TIPS investment would be when an individual sets aside retirement funds in an IRA. Purchasing $100,000 in TIPS locks in this amount in real terms. Whatever the inflation rate until the individual’s eventual retirement, the $100,000 would be completely “indexed”—its value would be increased to offset any increases in inflation.

TIPS have unique tax characteristics that make them better suited to IRAs or other tax-advantaged accounts. Because you pay tax each year on the annual interest payments you receive as well as the inflation adjustment, if you held the securities in a taxable account, you would pay income tax on money you wouldn’t see for years.

TIPS are not without risk. Since they are guaranteed by the federal government, they are considered to be free from credit risk; however, their price will move up and down with interest rates like other bonds.