With most investments, investors always recognize the possibility that they may end up losing money. But there's a difference between accepting a chance of loss versus locking in a certain loss. It seems ridiculous that any group of investors would ever consider making an investment where they knew they would lose money.
Yet that's exactly what some investors did last week. In frantic bidding for inflation-protected Treasury securities, also known as TIPS, investors showed that they were willing to accept negative real returns in exchange for protection against rising prices.
What negative yields mean
In the auction, investors agreed to an average annual return of (0.18%) on TIPS maturing in 2016. Technically, what investors did was to pay $1,017.54 for a five-year bond that will pay them $1.25 each year for five years and then pay them back $1,000 at maturity, plus the difference in the Consumer Price Index between now and then. So if the CPI rises 3% annually over the next five years, then investors will get a payment of $1,159 for their maturing TIPS bond.
Clearly, getting back $1,159 for $1,017 doesn't look like a negative return. But when you consider the purchasing power of your money, the return falls short of holding even with inflation. That's what short-term TIPS investors are accepting now, and even the longer-term inflation-protected bonds you get with shares of iShares Barclays TIPS Bond (NYSE: TIP ) yield just barely more than inflation.
Real losses running rampant
The thing is that a ton of investments are losing ground to inflation these days. Unless you invest for 10 years or longer, you won't find a regular Treasury bond yielding more than 3%. Average CD rates are almost universally below 3% right now.
Meanwhile, assuming that the historical average inflation rate of 3% will continue seems increasingly naive. Just in the past two months alone, inflation has risen a full percentage point. We're all quite aware of what prices at the gas pump have done recently. Interest in inflation-fighting plays like SPDR Gold (NYSE: GLD ) and iShares Silver Trust (NYSE: SLV ) are at or approaching record levels, as concerns about the U.S. government's credit rating weigh on investor sentiment. And even as the weak dollar has boosted earnings of U.S. multinationals DuPont (NYSE: DD ) , McDonald's (NYSE: MCD ) , and Eli Lilly (NYSE: LLY ) in their most recent quarterly reports, it also threatens to make imported goods that much more expensive for U.S. consumers, putting at risk the fortunes of companies that rely on domestic sales to stay in business.
Better inflation fighters?
The question you have to ask yourself is whether TIPS are really the best vehicles available to fight inflation. By accepting negative real yields on TIPS, many investors are answering that question with a resounding yes.
But if you're a bit more creative, you should be able to discover ways to profit from higher prices. Energy stock investors have already reaped big gains from the jump in oil prices, showing that at least some stocks will benefit from inflationary pressure going forward.
More broadly, how inflation affects companies in any sector depends on two things: how much higher prices affect what they have to pay to produce the goods and services they provide, and whether they can pass those higher costs on to their customers by raising prices themselves. Companies like Nike (NYSE: NKE ) that have strong brands and plenty of pricing power can easily pass on higher costs to product-hungry consumers. On the other hand, companies that are at the mercy of the free market are in danger of falling victim to higher prices.
Prepare for the worst
The hyperinflation that some now fear may not be the most likely scenario. But after years of relatively benign price rises, some inflation may be inevitable. Rather than sticking their heads in the sand and hoping for an economic miracle, smart investors will protect their portfolios from inflation's effects. With the right investments, you can join the smart crowd rather than being another of inflation's victims.
If you think energy stocks are the right way to beat inflation, take a look at our free special report detailing three promising companies poised to win from higher prices. To get instant access to the names of these three stocks, click here -- it's free.