How do I protect my portfolio against inflation?
Q: I’ve been reading more and more about the inflation in our economy. I’m trying to get ready to retire, but the growing rate of inflation has me worried. How can I protect my portfolio against inflation?
A: Inflation is a stealthy risk. In small amounts we hardly notice it, so it rarely gets the attention it deserves. However, even a small amount of inflation over a number of years can have catastrophic effects on your financial well-being. Two percent annual inflation over ten years will reduce the real spending power of your capital by almost 22 percent. That’s a huge loss of capital.
Unfortunately, inflation is currently much higher than two percent. In fact, the year-over-year change in the CPI between Q3 2020 and Q3 2021 was 5.9 percent. Inflation at that rate can do serious damage to your savings very quickly.
There are several ways to protect your portfolio from the ravages of inflation. Billionaire hedge fund manager Paul Tudor Jones said in a recent interview on CNBC that it is time for investors to “double down” on traditional inflation hedges, including commodities and Treasury inflation-protected securities. These can certainly help. However, in my experience, the best inflation protection you can build into your portfolio is to own a well-diversified portfolio of high-quality stocks and hold them for the long-term. There may be some near-term volatility with this strategy, especially as the Federal Reserve takes measures to fight inflation, but high-quality stocks have been outstanding inflation fighters over the years.
A common question I get right now is what to do about fixed income investments. As someone who started his career as a bond trader, I hate to say it, but fixed income is a terrible investment right now for two reasons. First, bond yields are low and are almost certainly going to go higher. When yields increase, bond prices fall. Consequently, fixed income holdings are almost certain to lose value as the Fed starts to reduce its program of quantitative easing. Second, traditional fixed income investments have no way to keep up with inflation. In fact, bond yields are currently below the inflation rate, meaning real bond yields are negative. If you invest in bonds today, you will lose money after accounting for inflation.
I also get a lot of questions about Treasury inflation-protected securities, or TIPS. TIPS are U.S. Treasury bonds that protect investors against inflation by pegging the bond’s face value to the CPI. For example, if the CPI increases by 5 percent, the face value of the bond also increases by 5 percent. The Treasury pays interest on the inflation-adjusted face value of the bond every six months. At maturity, the investor receives the inflation-adjusted face value as final payment.
TIPS are issued in 5-, 10-, and 30-year maturities. You can buy newly issued TIPS directly from the U.S. Treasury on the TreasuryDirect.gov website, or you can buy previously-issued TIPS through banks or broker-dealers. Like traditional bonds, TIPS currently pay negative yields.
When you buy a previously-issued TIPS bond, you need to pay attention to the bond’s inflation factor. The inflation factor shows the cumulative inflation since the bond was originally issued. For example, at the time of this writing a TIPS bond paying a coupon of 0.375% and maturing on July 15, 2023 has a market price of 106.148. However, this bond also has an inflation factor of 1.17514, meaning cumulative inflation since the bond was issued in July, 2013 has been 17.514 percent. To calculate your purchase price for that bond you would multiply the market price of 106.148 by the inflation factor to get the inflation-adjusted price of 124.739. In other words, if want to invest $1,000 in this bond, you will pay $1,247.39. If inflation is unchanged between now and maturity you will receive interest on $1,175.14 (the bond’s face value times its inflation factor) and a principal payment of $1,175.14 at maturity. Your inflation-protected yield to maturity will be -3.08 percent.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to:firstname.lastname@example.org