Simple Strategies to Inflation Proof a Portfolio!

[This post is written and copyrighted by FIRE Finance (http://firefinance.blogspot.com).]

Ostrich philosophy will not work!

Over a long time horizon inflation can create significant dents to a portfolio's performance. Turning a blind eye to it will not make it go away. Therefore, we have to address it in order to achieve our retirement goals. Naturally the following questions arise:

• What is inflation?
• What causes inflation in the first place?
  

To be honest, pundits are of divided opinions as to the exact causes of inflation, and to what extent each factor influences it. That, however, should not deter us to find creative ways of combating it. We can enlist several ways to tackle inflation. But we would like to draw our readers' attention to a couple of the simpler methods.

First tip is to buy TIPS!

We have already invested in TIPS (Treasury Inflation Protected Securities). These are investment vehicles created by US Department of Treasury to help protect against inflation. In layman's words our investment in TIPS never loses its original purchasing power. Here is our detailed analysis of TIPS covering scenarios of the market under inflation and deflation.

Great, how can we buy TIPS?

We can buy TIPS directly from the US Treasury. However we feel it is a better strategy to purchase ETFs and mutual funds that invest in TIPS owing to their flexibility, liquidity and low management fees.

• ETF - Those who love ETFs may consider iShares Lehman TIPS Bond (TIP).
• Mutual Fund - Vanguard Inflation-Protected Securities (VIPSX) is for fund enthusiasts.
  

Too good to be true?

• Do these ETFs and Funds really behave as they are expected to?
  
• Do they keep up with inflation?
  

In order to answer these genuine concerns we have put together a chart. We researched and acquired data for inflation of 2007 (12 months). Next monthly price quotes for VIPSX were downloaded, courtesy Yahoo. Finally a spreadsheet was created to generate the following chart.

Source of inflation rates: Inflationdata.com

[Please click on the above picture to see a bigger and clearer version of it]

A quick study indicates that prices of VIPSX followed the rise and fall of inflation rates rather faithfully. Needless to say that the evidence is very convincing. Let us next compare performance of VIPSX with a broad market index such as the Dow Jones Wilshire 5000 for the past 12 months.

[Please click on the above picture to see a bigger and clearer version of it]

The above comparison clearly shows that VIPSX has a highly negative correlation to the market in general. In other words VIPSX's behavior was opposite to that of the market. Now that is an investor's holy grail! Investing in asset classes that are less, or even better negatively, correlated to each other creates a truly diversified portfolio. Diversification is one of the fundamental principles in our philosophy of investing. In the long run it helps cushion the down slide of a portfolio.

As a follow up to this post, we shall next investigate the effectiveness of investing in commodities as a means to tackle inflation in our portfolio.

As always we are ever keen to hear about your experiences and opinions about tackling inflation. It is as an ever learning opportunity for us. Please feel free to drop by a comment.

Image Source(s): iStockPhoto

Related Posts