The Silent Value Killer: How to Prepare Your Portfolio for Inflation

For some investors, this nightmarish scenario could play in your head and keep you up at night: You retire with a huge portfolio, enough to withdraw around $50,000 per year. Ten years later, what cost you $50,000 a year now costs $67,000. Another decade later, you find yourself spending almost $90,000 for what originally cost $50,000 two decades prior. Your spending power is cut in half, and you’re running out of retirement money.

That’s how much a steady 3% inflation rate (the average annual inflation rate since 1913) can eat away at your money. Inflation moves slowly and silently and somehow catches you from behind. To help protect your portfolio from inflation, you may want to focus on the present and prepare for inflation.

Why Worry About Inflation?

Since the Great Recession, the average annual inflation rate has been well under 2%, according to the Bureau of Labor Statistics (2011 and 2012 were exceptions). As of this year (January to October), inflation stands at an average of 1.22%. That’s quite low, so what’s the big deal?

As of September, the Federal Reserve has decided to make its inflation target more flexible and inflationary. The Fed now plans to hold interest rates near zero for years to achieve an “average” 2% inflation. The key word here is “average.” That means the central bank is likely to overshoot 2% inflation in order to “average it out.” Higher inflation may be a consequence of this shift in policy.

Does that mean we’ll get an inflationary spike? Unclear. Inflation is relative and we’ll likely see a steady rise, regardless of how the rate fluctuates, because inflation has been rising since the Consumer Price Index was first introduced in 1913. 

How Does Inflation Affect Investments?

In a previous article, we addressed the possibility of U.S. interest rates going negative—even if nominal rates are above zero. If rates are slightly above the zero mark, common thinking is that the yields may not be all that attractive. But there’s a difference between seeking return on invested capital and the return of invested capital. And in a low-rate environment, getting just a little bit of the former and a near-guarantee on the latter might be more favorable than seeking higher yields through bonds that offer much greater risk.

There are quite a few inflation investing alternatives, according to Keith Denerstein, director, guidance at TD Ameritrade. Although it may be difficult to pinpoint investments suited for inflation, there are some ways to you can still protect your portfolio against inflation.

Treasury Inflation-Protected Securities (TIPS)

TIPS is a special type of Treasury bond that’s indexed to inflation. “The principal amount in TIPS is adjusted higher by the inflation rate each year, offering a level of built-in protection from inflation,” Denerstein explained. This means the purchasing power of the income you receive from a TIPS investment is more or less protected against inflation. TIPS also come in a variety of assets: “There are mutual funds and exchange-traded funds [ETFs] that hold TIPS, or you can invest in the bonds directly,” Denerstein added.

But what if you don’t want to give up the diversified variety of other bonds in your portfolio? Denerstein suggested shortening your maturities. “If you’re expecting higher inflation in the near future, a shorter maturity may offer a way to reinvest your principal in an issuance with a higher yield.”

Gold: A Traditional Inflation-Proof Investment

Gold’s a traditional and popular perceived “safe-haven” investment. It could gain value during periods of inflation, although not always in lockstep. It’s also often uncorrelated with stocks and bonds, and that matters, especially when you’re trying to protect your portfolio against inflation. You can gain exposure to gold in different ways: physical products such as coins and bars, mining stocks, exchange-traded products (ETPs) such as ETFs and exchange-traded notes (ETNs), and gold futures. Just be sure to do your research.

Bitcoin for the Bold

Bitcoin, as with most other cryptocurrencies, is highly speculative and volatile. Yet, as Denerstein said, “It’s likened to gold among some investors”—a possible investment choice if you’re able to take the associated risk of bitcoin. If the crypto angle is something you find appealing, yet you’re not quite a hardcore “hodler,” then do your homework to understand the risks involved in a bitcoin investment.  

Don’t Ditch Equities (Common and Preferred Stock)

During inflationary periods, some sectors and industries may perform better than others. “Equities do allow for some adjustment for inflation; earnings for some companies will move higher along with all other inputs and prices that drive the economy,” Denerstein mentioned. But be patient. “Equities tend to have a lag because not every company can charge higher based on the inflation rate, but the rise in prices (and earnings) will likely happen over time,” he continued.

Also, it might help to compare S&P 500 average dividends to yields on 10-year and 30-year Treasury notes. As Denerstein noted, “We’re in an atypical environment where dividend rates have been higher than those of certain vehicles such as U.S. Treasuries”—something to monitor if you’re taking inflation into consideration when allocating your portfolio. 

Another asset class to consider is preferred stock, which, according to Denerstein, “has properties of both bonds and common stock, tends to be less volatile than common stock, and its dividends are more protected because it’s higher in the capital structure.”

The Bottom Line

Just because the inflationary tide is rising doesn’t mean your ship’s going to sink. There are plenty of ways to prepare for inflation. It’s just a matter of knowing some inflation investing strategies and which choices might match your investment time horizon and risk tolerance.