Short-term investment instruments may mitigate effects of inflation

October 1, 2010

As the capital markets have improved, more investors have shifted their concern from weathering the financial crisis to anticipating the inflationary effects of rising federal spending and debt.

Key Points

Q I'm encouraged by the rebound in the stock market but am very concerned about inflation. What's a reasonable approach at this point?

Another option is Treasury Inflation-Protected Securities (TIPS). Introduced in 1997 and issued by the U.S. government, TIPS are fixed-income securities whose principal is adjusted to reflect changes in the Consumer Price Index (CPI). When the CPI rises, the principal increases, which results in higher interest payments. At maturity, an investor receives the greater of the inflation-adjusted or original principal amount. The inflation provision enables TIPS to preserve real purchasing power as well as act as a hedge against unexpected inflation.

However, keep in mind that TIPS prices also are affected by changes in real interest rates, so TIPS may not track inflation one-to-one in the short term or over longer periods of time. In fact, TIPS can lose market value if real interest rates increase. This is because the adjustments in interest and principal are tied to the CPI (a barometer of inflation) and not to overall market interest rates.

Commodity futures, as well as gold and oil, are perceived as effective inflation hedges because their returns are generally positively correlated with inflation. This is often the case, but it comes with a price tag. Commodities tend to be more volatile than stocks, and their returns do not always rise with inflation. Adding these assets to a portfolio may increase volatility within the portfolio, which could offset the perceived benefits of hedging. Keep in mind that a broad-based stock portfolio most likely already has commodity exposure through ownership of companies involved in energy, mining, agriculture, natural resources, and refined products.

Although the media have featured divergent opinions and theories about the effects of recent government actions on inflation, no one really knows how consumer prices will respond to the complex forces at work in the economy and markets. Investors should carefully review their financial circumstances and investment goals before making changes to their portfolio. Even with the prospect for higher inflation, investors who take a total return approach may be better served than those who choose assets based on correlation with the CPI. By choosing assets with higher expected long-term returns and maintaining broad diversification, investors can seek to grow real wealth and at the same time preserve the purchasing power of their dollars.

Q. We just had our first child and are updating our wills. What factors should be considered when selecting a guardian?

A. For individuals with minor children, perhaps one of the most important and difficult decisions is choosing a guardian. You must consider who is best able to cope with raising your children. Although your heart may tell you to select grandparents, be mindful of their age and ability to raise another family. Other options may include a sibling or close friend.

Factors to consider include ages of the proposed guardians and the ages of their children, ages of your children and the number of them who are still minors, and the health and financial situation of all parties. It is also an excellent idea to decide on alternative choices in the event your first choice is unwilling or unable to serve. If you name a married couple as guardians and one of them dies, consider whether you want the surviving spouse to act as the sole guardian. The same decision should be made in the event that the guardians become divorced.

Joel M. Blau, CFP, is president and Ronald J. Paprocki, JD, CFP, CHBC, is chief executive officer of MEDIQUS Asset Advisors, Inc. in Chicago. They can be reached at 800-883-8555 or blau@mediqus.com
or paprocki@mediqus.com