Worried about inflation? Here’s what you can do

June 19, 2014

As the capital markets have improved, more investors have shifted their concern from weathering the financial crisis to anticipating the possible inflationary effects of rising federal spending and debt. This thinking has led many to reassess their bond portfolios and even look at commodity futures as a potential inflation hedge.

I’m very concerned about future rises in inflation and the impact on my portfolio. What changes should I consider?

As the capital markets have improved, more investors have shifted their concern from weathering the financial crisis to anticipating the possible inflationary effects of rising federal spending and debt. This thinking has led many to reassess their bond portfolios and even look at commodity futures as a potential inflation hedge.

Higher inflation can hurt bondholders in two ways: through falling bond market values triggered by rising interest rates, and through erosion in the real value of interest payments and principal at maturity. This inflation exposure tends to impact the prices of long-term bonds more than those of short-term bonds.

Thus, investors can mitigate the effects of rising interest rates by holding shorter-term instruments. When interest rates are climbing, a portfolio with shorter-term maturities enables an investor to more frequently roll over principal at a higher interest rate. This can help inflation-sensitive investors keep up with short-term inflation and enable total-return investors to reduce their overall portfolio volatility, which can lead to higher compounded returns and growth of real wealth.

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 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.

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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 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 also 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.

While 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 potentially 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.

How are gains on the sale of a home taxed?

Your primary home is the home you live in most of the time and can be a house, houseboat, mobile home, co-op apartment, or condominium.

Single filers may exclude up to $250,000 of gain on the sale of their home. That amount goes up to $500,000 for married couples. You must have owned and lived in the property as your primary residence for at least 2 years during the 5-year period ending on the date of sale, but the 2 years do not have to be consecutive.

To determine whether you have a gain, start by figuring the difference between what you paid for your home and the price at which you sold it. The IRS terms are “amount realized” and “adjusted basis.” The amount realized is the selling price minus selling expenses such as commissions, advertising fees, and legal fees. The adjusted basis is the amount you paid for the home originally plus settlement fees and closing costs. You can also add in the cost of permanent improvements you made to the home.UT

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