No inflation in sight: Don't be complacent

Inflation is tame by almost any measure. Prices are up by less than 2 percent over the past year, despite the Fed’s purchase of more than $2 trillion dollars worth of bonds. In fact, for all of the hand wringing over the Fed’s “money printing” monetary policies, the weak economy has kept wages flat and forced many businesses to cut prices, which has kept a lid on overall prices. But when conditions improve, inflation could rear its ugly head. As a reminder, inflation occurs when the prices of goods and services rise and as a result, every dollar you spend in the economy purchases less. The annual rate of inflation over from 1914 until 2013 has averaged about 3.35 percent annually. That might not sound like much, but consider this: today you need $7,606.96 in cash to buy what $1,000 could buy in 50 years ago.

Currently, inflation is running well below the long-term average pace. As of April, the government’s measure of inflation, the Consumer Price Index (CPI), has increased only 1.1 percent over the last 12 months (1.7 percent without food or energy costs included.)

However, the Fed’s strategy to flood the economy with money could eventually unleash inflation in the future, an event against which every retirement investor must guard. The key is to attempt to grow your portfolio at a quicker pace than the rate of inflation, while keeping focused on the total risk level you are willing to assume. Not an easy puzzle to solve! And here’s one more sobering thought: there has not been any single asset that acts as a perfect inflation hedge.

The following are the assets most frequently used to protect portfolios against inflation:

Commodities: When inflation rises, the price of commodities like gold, energy, food and raw materials also increases. Many investors therefore turn to investments in these assets for protection, but as a former commodities trader, I must warn that this is a volatile asset class that can also stagnate or worse, lose money, over long stretches of time (see the massive drop in the gold market this year). Therefore, investors would be wise to limit commodity exposure to 3 - 6 percent of the total portfolio value.

Real estate investment trusts (“REITs”): The ultimate “real asset”, REITs tend to perform well during inflationary periods, due to rising property values and rents. But the nation’s housing bubble has cured most of us of the notion that one “can’t lose with real estate.” Real estate prices could stay depressed for a long period of time.

Stocks: Many investors don’t think about stocks as an asset class to combat inflation, but the long-term data show that stocks, especially dividend-producing stocks, tend to perform well in inflationary periods. That said, during short-term inflationary spikes, the stocks might plunge before reverting to the longer-term trend.

Treasury Inflation Protected Securities (“TIPS”): Bonds are susceptible to inflation, because rising prices can diminish a bond’s fixed-income return. But the US government directly offers investors inflation-indexed bonds, or TIPS, which proved a fixed interest rate above the rate of inflation, as measured by the CPI. Sounds great, right? When the expectation of future inflation is runs high, investors pay up for TIPS, which in the past year, has driven the interest rate on these bonds below zero. [In April, five-year TIPS drew a yield of negative 1.311 percent.] That’s not a typo: when investors get worried about future inflation, they are willing to pay the government now to protect them later. The current pricing of TIPS makes them hard to recommend, even as an “insurance policy” against inflation.

International Bonds: One of the dangers of inflation is that it destroys the value of the U.S. dollar. As a result, there is an argument to allocate a portion of a bond portfolio to a small percentage of international bonds, which are denominated in a foreign currency. This is another one of those asset classes that tends to be volatile.

While inflation may be looming, it’s important to underscore that a diversified portfolio, which takes into account your time horizon and risk tolerance, will go a long way towards providing protection. If you are worried about inflation, these other asset classes should be used sparingly to round out your overall allocation.