Over the long haul, inflation is one of the most destructive forces to your portfolio. Countless savers fall prey to its effects year after year, as they accept returns that guarantee steady reductions in their purchasing power over time in the name of safety and principal protection.
Smart investors realize that inflation is another risk that you have to guard against. But that doesn't mean that every method of fighting against inflation is a smart one. Even a coming new product from fund favorite Vanguard takes the wrong approach toward preserving the purchasing power of your portfolio.
TIPS and you
Yesterday, Vanguard announced that it expects to offer a new fund. Dubbed the Vanguard Short-Term Inflation Protected Securities Index Fund, the new product would track an index of TIPS -- short for Treasury Inflation-Protected Securities -- with maturities of less than five years.
TIPS are a special type of Treasury bond. With most bonds, you buy the bond, receive interest payments over the years, and then get your money back at maturity. But with TIPS, the total amount you get paid when the bond matures rises along with inflation. So if you pay $1,000 for an inflation-protected bond and inflation rises a total of 20% by the time it matures, then you'll get back $1,200 rather than $1,000.
The Vanguard fund isn't the first to attack inflation using TIPS. The iShares Barclays TIPS Bond (NYSE: TIP ) ETF is extremely popular, with more than $23 billion in assets under management. But Vanguard argues that the short-maturity focus of its new fund, which will also be available in ETF form, will "generate returns more closely correlated with realized inflation and ... offer investors the potential for less volatility of returns relative to a longer-duration TIPS fund."
That all seems to make sense. But the problem is that the returns on short-term TIPS are worse than ever right now.
In fact, if you look at the rates in the secondary market on TIPS maturing in 2017 or earlier, you'll notice that every single one of them has a negative yield to maturity. Go beyond mid-2014, and the TIPS all carry rates of -1% or worse.
In plain English, a negative rate on TIPS means that you're guaranteeing yourself a loss of purchasing power. Even if the Consumer Price Index skyrockets, you'll still earn a return that averages a percentage point per year less than the inflation rate.
Better ways to protect yourself
If you're dead set on short-term securities with inflation protection, your better bet is to buy Series I savings bonds. The bonds are pegged to the CPI just like TIPS, and their rate is currently pegged to the rate of inflation exactly. That guarantees you a better return than the -1% return on short-term TIPS. Moreover, you get to decide how long you hold on to an I-bond, with a maximum maturity of up to 30 years.
But if you're not happy with just breaking even, an alternative way to fight inflation is to buy stocks that benefit from rising prices. For instance, if you think the next wave of inflation will come from pricier crops, then fertilizer companies Terra Nitrogen (NYSE: TNH ) and PotashCorp (NYSE: POT ) should benefit from farmers seeking to maximize their profits in a high-price environment. On the other hand, if you think real estate will rebound, then housing stocks might be a smart bet.
Another solution is to go with companies that have enough brand loyalty to pass through increases in their raw-materials costs to consumers. Coca-Cola (NYSE: KO ) and McDonald's (NYSE: MCD ) aren't immune to the impact of rising input costs, but they're in a better position than many of their peers to increase prices to consumers without fear of losing big swaths of their customer base.
One thing's for sure: It's madness to voluntarily accept a negative real rate of return when there's any alternative. Under more normal circumstances, Vanguard's coming fund may make sense. But right now, you'd have to be desperate to settle for its sure losses.
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Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.