Inflation and the Rising Tide: Protect Your Assets from the Storm

There is an old expression: A high tide lifts all boats. A rising tide can also sink them. And as signs of improvement in the economy appear on the horizon, there is a real possibility that inflation will come with the tide. Why worry about inflation? Well, inflation is an investor’s worst nightmare. For retired people living on a fixed income, it can devastate savings and lifestyle. As the holder of a bond or certificate of deposit, the purchasing power of regular interest income is affected. As a stock investor, stock prices can be affected as profit margins and earnings on your stock holdings are impacted by higher costs of inputs such as energy, precious metals, and labor.

Right now, Wall Street is in a good mood. For the quarter just ended, the Dow gained about 14%, the S&P rose 14.5%, and the NASDAQ rose 15%. In fact, the last time the Dow experienced such a large quarterly rise was in the fourth quarter of 1998, when it rose more than 17% as the dotcom bubble was forming. This quarter’s rally continued a trajectory that began in mid-March 2009. It has been driven primarily by glimmers of light at the end of the tunnel. A variety of positive remarks from Federal Reserve Chairman Ben Bernanke contributed to a more optimistic view. Residential real estate sales continued to come back primarily driven by a first-time homebuyer tax credit. Corporate profits have increased.

The popular “cash for junk” program stimulated auto sales, and by some measures consumer spending rose marginally even without the impact of auto sales. Despite Wall Street’s rally, Main Street continues to suffer: unemployment continues to rise, business and personal bankruptcies are up, bank failures are at an all-time high, and the dollar continues to weaken fueling fears of inflation ahead. Signs of higher inflation ahead are on the radar screen: all the government economic stimulus here and abroad coupled with mounting public debt; the Federal Reserve’s projected end of a program in March 2010 that will likely lead to higher mortgage rates; a Federal Reserve interest rate policy that has nowhere to go but up and rumors that foreign governments and investors may not want to continue at the current pace of supporting our borrowing habit. So how do you position yourself to profit whichever way the tide turns?

Now, more than ever, it is important to have a controlled risk approach to investing.

This centers on an age-based allowance that includes exposure to multiple assets. That is why we will continue to manage portfolios with an allocation to bonds and fixed income, but there are ways to hedge against the impact of inflation and still allow for growth.

1.) Include Dividend-Paying Capital: Using mutual funds or ETFs that focus on dividend-paying stocks will help increase income and yield. Dividend-paying stocks have averaged close to a 10% annual return compared to a total return of less than half that of stocks that rely solely on capital appreciation. Better yet, consider stock mutual funds, or ETFs, that focus on stocks that have a history of increasing dividends.

2.) Keep it short: By owning bonds, ETFs or bond mutual funds that have a shorter average maturity, you reduce the risk of getting locked into less valuable bonds when higher inflation drives up future interest rates.

3.) Hedge your bets with inflation-linked bonds: Fixed rate bonds do not offer inflation protection. A bond that has changes linked to an inflation index (such as the consumer price index) such as TIPS issued by the US government or ETFs that hold TIPS (such as iShares TIPS Bond ETF – symbol TIP) offer an opportunity to that a bond investor gets periodically compensated for higher inflation.

4.) Float Your Boat With Variable Rate Notes: These medium-term notes are issued by corporations and reset their interest rates every three to six months. So if inflation increases, the offered interest rate will probably increase. Yields are generally higher than those offered by government bonds due to the higher credit risk of the issuer.

5.) Add Junk to the Trunk: High-yield bonds are issued by companies that have been downgraded, much like homeowners with bad credit taking out a mortgage. The yields are set higher than most other bonds due to the increased risk. However, as inflation rises with a growing economy, the prospects for companies emitting junk improve and the perceived risk of default may decrease. So, as the yield gap between these “junk” bonds and Treasuries narrows, these bonds offer a “bang” to investors.

6.) Own gold and other commodities: Whether as a store of value or as a hedge against inflation, precious metals have a long history with investors seeking inflation protection. It is generally best to focus on owning physical gold or an ETF that is directly linked to physical gold. The tax treatment of precious metals is higher due to their “collectible” status, but this is a lower price to pay for some protection against inflation. And because demand for commodities generally increases with an expanding economy or a weak dollar (in the specific case of oil), owning funds that hold these commodities will help protect against the inflationary impact of an expanding economy.