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Inflation-proofing your portfolio
By Karen Lee, Karen Lee & Associates
Monday, June 15, 2009

With prices falling on everything from energy to food and real estate, inflation may be last on your list of things to worry about. If you’re like most individual investors, you are operating squarely in protection mode, considering moving out of what you perceive as riskier equities and into the safer havens of bonds or cash. While those moves may feel right in the wake of deep portfolio losses and an ongoing recession, they would actually increase your risk by diminishing your purchasing power if inflation rears its head.

Because the market is likely to move up suddenly if investors regain some confidence, it’s best to build in some inflation protection before you think you need it. Consider these three portfolio moves:

  1. Stick with stocks

    While rising inflation can hurt profits in the short- term, because companies eventually can increase costs for consumers, inflation often has a neutral effect on stocks. In fact, historically corporate profits have outpaced inflation. Today, U.S. companies with sizeable overseas earnings or foreign companies look well-positioned to succeed if inflation takes off.

    If you have money on the sidelines, you might consider investing in utility companies. Offering 6 to 8 percent on their dividends, a significant improvement over the interest from your bank account, these stocks offer a relatively low risk alternative to cash.

  2. Be wary of bonds

    If you’re unable to steer away from bonds, stay on the shorter duration end of Treasury securities, particularly as the deficit and supply of Treasury bonds increase. In 2007, net issues of Treasury Securities were $237.5 billion. In 2008, this figure was $1.239 trillion, and likely to continue moving higher going forward. This along with the potential drop in demand for these securities as foreign investors repatriate assets hurt the potential returns of Treasuries. Today, their low yields relative to historical levels also provide more downside than upside.

  3. Find a place for commodities

    Conventional wisdom holds that gold and other commodities provide a useful hedge for inflation. After all, in most cases, when inflation rears its head, the price of gold goes up. Since the end of World War II, for the five years in which U.S. inflation was at its highest, 1946, 1974, 1975, 1979,and 1980, the average real return on stocks, as measured by the Dow, was -12.33%, compared to 130.4% on gold. However, there are problems with relying on gold alone as a hedge to inflation. Specifically, from 1980 to 2001, prices in general doubled, but gold’s price fell from $850 to $257.

    Accordingly, in addition to recommending gold, to further diversify and hedge inflation, we are beginning to take positions in REITs, especially those in the capital-raising stage that can take advantage of buying opportunities in the down market. Residential REITs that invest in student and senior housing as well as diversified REITs that combine industrial, residential, and office properties are also attractive. A global uptick in spending or ensuing inflation could bring about higher consumable commodity prices.

Big picture, there’s no question that the recession demands a much keener focus on your portfolio. I’m advising my clients that current volatility dictates that we re-balance their portfolios more often, at least twice a year, to ensure they are not taking on more risk than they can afford. We’re also keeping a mindful eye on fund expenses.

Today, with consumers hanging onto their wallets, inflation seems a distant worry. Yet, the market’s ultimate recovery could deal a swift blow to your purchasing power for goods and services, and make stocks’ bargain basement prices a distant memory. Accordingly, participating fully in the market’s eventual rise requires putting some inflation protection in place today while inflation worries and prices are low.

Karen Lee, CFP, CLU, ChFC, MSFS, AEP, is President of Karen Lee & Associates, a financial advisory firm in Atlanta, GA.