Protecting Your Investment Portfolio from Inflation

In order to combat the recent financial crisis, central banks around the world have increased the money supply by trillions of dollars. That means that, over the long term, there is the potential for a resurgence of inflation, or a rise in prices, which would significantly erode the purchasing power of your investment portfolio. Fortunately, however, there are some simple steps you can take to help protect your portfolio from the ravages of inflation.
One inflation protection strategy is to maintain an allocation in your portfolio to gold. As a hard asset, gold tends to increase in value during periods of inflation. There are several ways to gain exposure to gold. The most straightforward way is by actually purchasing gold bullion, which you can do through many banks. The problem with owning physical gold is that storage costs can be quite significant. Another way to gain exposure to gold is to buy shares in gold-producing companies, such as gold mining companies. The drawback of owning gold companies is that they don’t fully track the price of gold. That means that if, say, the price of gold rises by 20% in a year, the gold company’s stock price may only go up by 10%. As a result, you don’t get the full benefit of the rise in the price of gold.  A better way to gain exposure to gold is through specialized investment products that are designed to mirror the price of gold. For example, you can purchase shares in an exchange-traded fund, or ETF, that tracks
the price of gold. This way, you can be sure that you will be able to fully benefit from a rise in the price of gold.
A second strategy to protect yourself from inflation is through commodities. Like gold, commodity prices generally rise during inflationary periods. While there are exchange-traded funds (ETFs) that track prices of commodities, such as oil, commodity prices can be extremely volatile, as we saw during the recent financial crisis, when the price of oil went from $140 a barrel down to $30 a barrel. If you had invested in an ETF tracking the price of oil during that period, you would have suffered extremely painful losses. A less risky way to gain exposure to commodities is by owning shares in companies, such as oil producers. There are many excellent international oil companies. While you won’t receive complete exposure to the price of oil, you’ll be more protected on the downside in case of a dramatic fall in oil prices.
Finally, a third way of achieving inflation protection is through real return bonds. In the United States, these are referred to as TIPS (Treasury Inflation Protected Securities). Real return bonds are securities that are specifically designed to increase in value with inflation. Unlike oil or commodities, real return bonds by definition rise in value with inflation. The way it works is that the bond payments are explicitly linked to a measure of inflation, usually the Consumer Price Index (CPI), which is a broad measure of price changes in the economy. You can purchase real return bonds through a broker, or, in the United States, you can purchase directly from the website of the U.S. Treasury Department.
By holding some of your portfolio in gold, commodities or real return bonds, you can feel secure in the knowledge that your portfolio is positioned to better maintain its purchasing power in a prolonged period of rising prices.