4 Ways To Protect Your Portfolio From Inflation

Baby-boomers started turning 65 — and retiring en masse — just a few years ago. This generation, born between 1946 and 1964 on the optimism and excitement and relative prosperity of the post-war boom, is getting older indeed. As more and more baby-boomers file for Social Security, the demand for safe, income-generating investments should remain at least steady, but will more likely increase.

That’s because, for many retirees, income from investments is meant to complement their Social Security income. This also means that, for current and new retirees alike, their retirement savings will have to last as long as possible so they can live comfortably, without having to take a substantial cut in the quality or quantity of goods and services they buy and use.

#-ad_banner-#In economic terms, this means retirees strive to maintain the same standard of living — or at least close to it. And to do so, their spending levels have to move higher, in line with inflation.

Keeping Up With Inflation
Now, there are several statistics dealing with consumer inflation — from the most commonly used one, the CPI (Consumer Price Index) to “core” CPI (this one excludes food and energy, which, while controversial to some, eliminates much of the month-to-month volatility of the CPI index) to yet another index, personal consumption expenditures (PCE). The latter index, produced by the Department of Commerce, covers a wide range of household spending and is preferred by the Federal Reserve, although the central bankers also look at other measures of inflation as well.

Why does all this matter? Because while everybody’s situation is different and we might feel our own expenditures inflate faster (or slower) than posted inflation numbers, these “official” inflation numbers are rooted in real life and impact everything from mortgage rates to bond yields to yields on stock indices — not to mention the Fed’s interest-rate policies.

Inflation, whichever way you measure it — and even if it’s relatively benign (the average CPI for the past 12 months was 1.6%) — is going to impact portfolios. The table below provides a simple calculation illustrating the inflation-adjusted size a portfolio needs to maintain the same purchasing power (using inflation levels of 2% and 4% as examples).

No, I don’t believe we will see anything resembling a 4% inflation rate anytime soon. The Fed is watching this number closely, and too many factors have to line up for that to become a reality at this time.

But nobody could fault investors who remember the 1970s, when inflation ran as high as 13% by the end of the decade, for sometimes overestimating their own inflation expectations and preparing for much higher spending down the road than they might end up needing. After all, better to have more than not enough.

However, keep in mind that the suite of best-suited investment recommendations and strategies might change together with the average inflation expectation. For now, here are some inflation-related thoughts to consider:

1. If your goal is to beat inflation and continue to accumulate long-term spending power, be careful with high-yield. Because stock and bond markets don’t exist in isolation, stocks that yield significantly more — say, three times more than the benchmark 10-year Treasury Note (which currently yields 2.5% and is considered minimal risk) — are, almost by definition, high-risk investments. This risk comes from low growth (the highest-yielding stocks are the slowest-growing, and they will do little for your portfolio’s principal) and, in the case of closed-end funds, from the use of leverage.

This does not mean that, even if you are concerned about inflation, you have to give up on this area altogether. For example, my colleague Nathan Slaughter is a fan of closed-end funds (CEFs). Over at High-Yield Investing, Nathan and his subscribers own a few well-managed high-yielding CEFs, which with the ups and downs that sometimes come with them, should be able to keep up with inflation.

2. Look for companies that grow dividends at an inflation-beating pace. Not only will your dividend income outpace inflation, but your portfolio principal will have a chance to grow, too, as more investors flock to these same stocks.

3. Look for value opportunities. We can define value companies as those underpriced relative to their future dividend prospects — sometimes these will result from an unjustified sell-off, sometimes this will be an aftermath of a multi-month slide, and sometimes you should be willing to buy a company that barely pays a dividend on the research-backed belief that, in the foreseeable future, it will increase the payout.

This strategy allows investors not to overpay for an income asset. And when they don’t overpay, chances are that the principal will appreciate faster than at a time when “a full price” was paid, providing a more efficient use of every investment dollar in terms of potential appreciation.

Investors adhering to this strategy should be aware that value traps — stocks that nobody wants for a good and valid reason — exist. But some risks notwithstanding, this is a valid inflation-beating strategy and it deserves more recognition in the income community.

4. Continue reinvesting dividends. Dividend reinvesting allows for some extra portfolio boost that can add to its inflation-beating capacity because of the simple fact that these assets are not allowed to be idle. If you are still in an accumulation phase, reinvesting dividends sounds like a strategy that’s easy to comprehend and execute. However even retirees who don’t need every last cent of income their portfolio generates should utilize this strategy. Check your portfolio income need against your portfolio income potential and consider reinvesting some of the dividends if you currently don’t need that income.

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