How to Inflation-Proof Your Portfolio

Inflation might be on the horizon. What can you do to protect your investments?

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With widespread worries that the U.S. economy is headed for stagnation and slow growth, the last thing you should have to worry about is guarding your portfolio against inflation, right?

Wrong.

We might not see inflation in 2011 or even 2012, but investors who witnessed the rapid escalation of prices in the 1980s know that the specter of inflation is always just around the corner. Although there's been a lot of recent buzz about the economy slowing down and prices falling, some analysts expect the Fed to raise interest rates soon to bring inflation back to a more "normal" level of about 2 to 3 percent. Whether that happens in two weeks or two years, investors should be prepared.

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"Inflation is probably the biggest secret enemy of people's portfolios over time," says James Early, advisor of the Motley Fool Income Investor newsletter and a former hedge fund analyst. "It's sort of an insidious force that decays your purchasing power over the years if you have a long-term inflation."

The risk is magnified for retirees and other investors on fixed incomes, says Christine Benz, director of personal finance at investment research firm Morningstar and author of 30-Minute Money Solutions. Except for Social Security benefits, which include cost-of-living increases, those on fixed incomes can't rely on any other built-in upward trends in income. And in the wake of the financial crisis and credit crunch, many people have socked away their money in CDs or money market accounts, which, according to Early, generally underperform inflation. With inflation, products previously considered "safe" places to park your money might now hurt your bottom line, he says.

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Fortunately, there are several strategies and investment products to help combat the effects of inflation. Here are some tips to help ensure that the money you've invested grows in step with inflation:

Invest in TIPS. Treasury Inflation-Protected Securities, or TIPS, are bonds issued by the U.S. Treasury in denominations of $100. The face value of the bond increases with inflation, which is determined by the Consumer Price Index (CPI) every six months. The Treasury then pays interest (fixed at issue) on the adjusted value of the bond, a practice that's intended to generate a gradually rising stream of interest payments as inflation rises.

For example, suppose you invest $1,000 in a 10-year TIPS bond with a fixed interest rate of 2 percent. If inflation is 3 percent over the next year, the face value of the TIPS bond increases to $1,030. The 2 percent interest payment is then calculated from this adjusted amount. If inflation turns out to be 3 percent the following year as well, the face value of the bond would increase to $1,060.90 and the 2 percent interest payment would be calculated again from this new inflation-adjusted value.

TIPS are also considered to be very safe investments. Because the U.S. government backs them, investors will never receive less than the original face value of the bond at maturity (five, 10, or 30 years), even in the fairly unlikely possibility of deflation.

"I come back to TIPS as the first line of defense," says Benz. "They have explicit inflation protection and you can buy them fairly inexpensively, so it's not a complicated investment strategy that you need to pay someone a lot of money to handle."

Investors can purchase TIPS directly from the U.S. Treasury at www.treasurydirect.gov, but many investment firms offer products that include a TIPS focus as well. Benz and Early both like the Vanguard Inflation-Protected Securities Fund (VIPSX) and Benz says the PIMCO Real Return Fund (PRTNX) is also a good choice.

Increase your stake in commodities. Commodities tend to rise in value as prices of other goods and services rise, so they're a particularly good gauge of inflation. "If food prices are going up, the idea behind commodities is that you've got exposure to wheat prices and pork prices," says Benz. "You essentially get to participate in those price gains and that helps offset the fact that you're paying more for all this stuff at the grocery store or at the pump."