5 Ways to Prepare Your Portfolio for Inflation

Aug. 16, 2012 — -- Inflation – the demon of investment returns – is expected by many to increase in the coming months after a long period of calm. Inflation is the upward movement of prices. When it's high, you need significantly more money to buy the same basket of goods than you did previously. Viewed from the other direction, inflation is the downward movement of the value of money.

Increasing inflation can play havoc with your investment portfolio and, in extreme cases, can make assets irrelevant by destroying economies. An extreme example is Zimbabwe, a country now using the U.S. dollar because in 2008, its own currency inflated 6.5 sextillion percent (a number with 21 zeroes).

Here in America, economists are scanning the horizon for signs not of such hyperinflation, but of an infinitely more subtle variety. Some project that an upsurge in inflation could begin with an increase in the annual rate from the current 1.7 percent to 2 percent by next spring.

Already, we have rising food and drug prices – but such essential items always go up faster than the overall rate of inflation. When the price of pretty much everything increases more rapidly than before, then you have rising inflation.

One reason some people expect inflation to increase is that the U.S. has been printing a lot of currency in recent years while the economy hasn't grown much, resulting in more dollars chasing the basically the same amount of goods and services. While some fixate on printing more currency as a sure sign that inflation will increase, a more balanced view holds that this factor alone doesn't necessarily mean an upswing.

A better reason to expect inflation to rise is that its ebb and flow is cyclical, and it has been historically low for years. Inflation tends to rise and fall with what's known as the business cycle – the economy's pattern of expanding with growth and then contracting toward recession. The business cycle has historically averaged about seven years.

Why should increasing inflation matter to investors? Because investing is all about getting returns that exceed inflation – and then some. If inflation weren't a factor, you could preserve capital in troubled markets by just keeping all of your money in your mattress.

But with increasing inflation widely forecast, investors face the challenge of fortifying their portfolios against it. Here are some strategies to consider:

• Investing in inflation-protected government debt: I-bonds (the "I" stands for inflation-indexed) and TIPs (Treasury Inflation-Protected Securities).

Both of these investments protect returns from inflation, but it's important to remember that the government has an inherent conflict of interest: The higher the rate of inflation cited in government statistics, the higher rates it must pay on these investments. Remember that the actual inflation rate at any given time may be higher than Uncle Sam is telling us.

• Buying commodities. Natural resource commodities (metals, chemicals, timber, energy, coal) tend to rise in price at a rate similar to inflation because more dollars are chasing the same amount of resources. Commodities are highly accessible through exchange-traded funds (ETFs). But they can be a tricky investment because they require vigilant monitoring; you can't just buy them and sit back.