Inflation 3 (April, 2010)

Welcome to the final installment in my series about inflation. As I've mentioned before, inflation is the "silent killer" of portfolio value, and is very important for investors to understand. Inflation is a phenomenon that has existed since the advent of money, thousands of years ago. It will continue to be a force into the future, probably as long as we still measure value in currency. This month, I will be bringing the series to a close with some thoughts about the practical impact inflation has on a portfolio and a few strategies that investors use to combat inflation's effect.

As I've mentioned several times, inflation eats away at the value of your money in silence. If you keep $100,000 under your mattress, in 10 years with 2% inflation (the approximate, long term average) it would have the same value as about $82,000 today. You would lose $18,000 in purchasing power without losing a dime of your money! This fact is what leads financial advisers to caution strongly against leaving your money "under the mattress" or in low yielding savings and checking accounts for long periods of time.

Fortunately, there is good news for investors. There are several strategies and securities that can be used to minimize the effects of inflation for everyday investors.

Younger investors who own mostly equity (stock) type instruments don't need to worry about inflation. Over time, the earnings of the companies they own will increase with inflation, and this will be reflected in their stock prices. As we have seen over the last several years, stocks may not increase for years at a time but in general earnings should increase with inflation.

Another common "hedge" against the effects of inflation is commodities. Commodities are raw materials such as oil and gold that can be bought in the financial markets. They can also be bought in the form of diversified funds that track the price of multiple commodities at once. The value of commodities is measured in dollars. As dollars have less and less value, the number of dollars needed to value a certain amount of commodities goes up. Buying commodities negates the effects of inflation by exchanging your money for an asset that isn't affected by the change in value of currency. Later, you can sell the commodities for an increased price since dollars have been depreciating due to inflation.

Other strategies have to do with investing in foreign currencies. The theory is that since inflation doesn't have the same impact everywhere in the world, investing in the right foreign currency will lessen the impact inflation has on your portfolio. This is difficult to do because it involves projecting interest rates and inflation rates in the U.S. as well as the country in which you plan to invest.

Finally, the most common way investors can mitigate inflation is through U.S. Treasury Inflation Protected Securities, or TIPS. TIPS work like normal bonds; they have a purchase price and pay interest. The principal is adjusted to account for CPI periodically and this indexes it to inflation (approximately). One problem with TIPS is the way they are taxed. The gains on principal are taxed even before they are realized (the so called "phantom tax"). Even so, TIPS can be an excellent way to minimize inflation effects on part of your portfolio.

Inflation is a very important topic for investors to understand. It must be accounted for and kept in check because it has the ability to diminish the value of a portfolio over long periods of time. There are several techniques for diminishing the effects inflation will have on a portfolio, but there is no real "silver bullet". Using a variety to techniques will yield the most effective inflation strategy.

I hope you've enjoyed this series. Inflation is a very complex topic and there are entire fields of study devoted to it. Although this has been more of an overview than an in depth study, I hope you have learned a little bit more about inflation, its causes and what investors can do to mitigate its effects. If you are interested in learning more, there is a wealth of information and statistics on the internet, or feel free to contact me at any time.