Preparing For Inflation

The New York Times appears to be attempting to give investment advice to those who fear inflation in this article. They admit, and I agree, that inflation probably won't be a problem this year. But many think it will rear its ugly head before too long. They make four suggestions for creating a portfolio less susceptible to inflation. I think they only got one or two right, and left one out.

Their suggestions:

Short-Term Fixed-Income

Fixed-Income securities (also generally known as bonds) are a terrible investment during inflationary times. That's because the coupon the investor earns remain unchanged, despite what inflation does. So if inflation hits 6%, and your bond coupon is only 4%, then you've just lost 2%. So instead, they tell readers, just invest in short-term fixed income. That way, every so often, you can buy more fixed income and keep up with inflation. This doesn't seem like a great idea, because even if you take advantage of higher yield bonds every few months or so, you still experience some timing problems where inflation can bite. Admittedly, this is still better than holding cash.

TIPS

These are Treasury Inflation-Protected Securities. By definition, their purpose is to guard against inflation. Sounds great, right? Maybe. But if you are a believer in the theory that a Treasury bubble is being created, and that Treasuries will eventually crash and burn, then that affects TIPS. If the value of Treasury securities plummets, so does the value of TIPS. TIPS are also dependent on the Consumer Price Index, which some theorize can be manipulated by the government through changing the basket of goods reflected in CPI to make inflation seem lower.

Real Estate

This one might be a good one, but I'd be a little worried about it. Sure, maybe we're at the bottom of the real estate trough. But maybe not. As unemployment continues to increase, the real estate market is not likely to get much better. And even if the economy begins to grow again at a snail's pace, I think it's safe to say that the real growth rate real estate experiences over the next three to five years is likely to be quite low. As in, you'll be lucky to see 3%. One solution could be to rent out a house you buy. That way, every year you can raise that rent based on new price levels. But that still means that, if inflation increases a few months into the lease, you lose. Still, this might not be a bad idea -- just not the best one. As long as you go into it not expecting much more than a few percent in real return over the next several years, then you'll probably be okay.

Commodities

Finally, the Times stumbles over a good one. Commodities are probably one of the best hedges for inflation. After all, commodities are just goods that people use. Inflation is essentially defined as their increasing in price. The trick with commodities, however, is figuring out which ones are least likely to experience other negative market shocks. For example, if an industry that uses a given commodity has a problem, then despite inflation, that commodity might decrease in price. I think commodities make sense, but even here there can be significant risk if you pick the wrong ones.

The one they left out:

High-Dividend Stocks

If inflation increases, so should revenues. When companies charge more for their products and services, nominal profits should increase as well. That means higher dividends and stock prices. If the stock market was in any sort of bubble, that might not mean anything, as stock prices could still plummet. But given that the stock market has taken a beating over the past year or so, prices probably won't decrease too substantially at this point, especially over a three to five year time horizon. Since inflation probably won't manifest itself until 2010, that just means we have a little more time to make sure the stock market has at least stabilized. There's always the risk of picking the next AIG, GM or Citigroup, but if you pick some historically strong, tangible product driven companies that have good dividends, then you probably have less to worry about. Fireworks? No. Safety? Probably.