Protecting your assets against inflation

The Federal Reserve recently announced that it would engage in its third round of "quantitative easing" by purchasing $40 billion per month of mortgage-backed securities to spur economic growth.

Whether the plan will work is debatable. What is not debatable is that the Fed's action is stirring fears of inflation.

Inflation occurs when the prices of goods and services rise, and, as a result, every dollar you spend purchases less. The annual rate of inflation over the past 60 years or so has averaged about 3.8 percent. That may not sound like much, but consider this: Today you need $8,693.55 in cash to buy what $1,000 could buy in 1952.

Currently, inflation is running well below the long-term average pace. However, the Fed's strategy could unleash inflation in the future, an event against which every retirement investor must guard.

The key is to grow your portfolio at a quicker pace than the rate of inflation, while staying focused on the risk you are willing to assume. And here's a sobering thought: There has not been any single asset that acts as a perfect inflation hedge. The following are the assets most frequently used to protect portfolios against inflation:

Commodities

When inflation rises, the price of commodities like gold, energy, food and raw materials also increases. However, this is a volatile asset class that can also stagnate or worse, lose money, over long stretches of time. So investors would be wise to limit commodity exposure to 3-6 percent of the total portfolio value.

Real estate investment trusts

The ultimate "real asset," REITs tend to perform well during inflationary periods due to rising property values and rents. But the nation's housing bubble has cured most of us of the notion that one "can't lose with real estate." Real estate prices could stay depressed for a long time.

Stocks

Many investors don't think about stocks as an asset class to combat inflation, but the long-term data show that stocks, especially dividend-producing stocks, tend to perform well in inflationary periods. That said, during short-term inflationary spikes, the stocks can plunge quickly before reverting to the longer-term trend.

TIPS

Bonds are susceptible to inflation because rising prices can diminish a bond's fixed-income return. But the U.S. government directly offers investors inflation-indexed bonds or Treasury inflation protected securities ("TIPS"), which provide a fixed interest rate above the rate of inflation, as measured by the CPI. Sounds great, right? Unfortunately, because the expectation of future inflation is currently running high, investors are paying up for TIPS, which has driven the interest rate on these bonds below zero. That's not a typo: investors are so worried about inflation, they are willing to pay the government now to protect them later. The current pricing of TIPS makes them hard to recommend, even as an "insurance policy" vs. inflation.

International bonds

One of the dangers of inflation is that it destroys the value of the U.S. dollar. As a result, there is an argument to allocate a portion of a bond portfolio to a small percentage of international bonds, which are denominated in a foreign currency. This is another one of those asset classes that tends to be volatile.

While inflation may be looming, it's important to underscore that a diversified portfolio, which takes into account your time horizon and risk tolerance, will go a long way toward providing protection. If you are worried about inflation, these other asset classes should be used sparingly to round out your overall allocation.

Jill Schlesinger is the editor at large for CBSMoneyWatch.com and writes this column for Tribune Media Services.