3 Ways to Inflation-Proof Your Portfolio

If rising stock markets are a reliable guide, then it appears that the threat to the survival of our entire financial system has abated -- at least for now. Gone are the daily discussions of systemic risk, the extraordinary measures that the Federal Reserve and the government have taken to shore up the health of key markets and businesses, and the plunging share prices that resulted.

Some believe that eventually, we'll have to pay the price for the stability we've gained. Specifically, due to the trillions of dollars that have been added to the economy, inflation may result. Although the question of whether inflation is inevitable is one that many analysts have argued strongly about, both for and against, what investors need to know is how to protect themselves from inflation if and when it occurs.

Traditional inflation hedges
In simplest terms, inflation makes money worth less compared to the goods you buy with it. Most of the traditional ways to protect yourself from inflation focus on using money now to buy things that you can sell later, after inflation has increased their price.

Historically, gold and silver have served as an archetype for inflation hedging. Because of their former use as currency, there's a precedent for using precious metals as a gauge of value that few other types of tangible property share.

More recently, though, the availability of simple ways to trade in other commodities, from farm goods like wheat and corn to energy products like crude oil and natural gas, has allowed investors to diversify their inflation-hedging strategies. For instance, many have pointed to the inverse relationship of oil prices and the dollar during oil's rise to record highs last year as proof that some sought protection against dollar devaluation and inflation.

Finally, inflation-indexed securities like TIPS give investors a direct way to earn fixed after-inflation real returns. With prices linked directly to the consumer price index, bondholders see their interest payments and eventual payout at maturity rise if inflation rears up during the period they own their bonds.

ETFs make it easy
In each of these three categories, you can find exchange-traded funds (ETFs) that make hedging much easier. Here's a sampling for each of the categories discussed above:

Source: Morningstar.

These and other ETFs can help you stay ahead of inflation in whatever manner best suits your investing style. But there are some things you should keep in mind when using ETFs:

• Watch for tracking error. Some ETFs are designed to track the price of a particular commodity or stock index. But not all of them act the way you'd expect. Check out past price history to make sure your ETF actually does what you think it should do.
• Don't overpay. Just as with any fund, paying too much in fees will eat away at your returns. Even if you're right and inflation pushes your ETF's price higher, you won't benefit as much from a high-fee fund as you will from one with lower fees.
• Buying stocks versus actual commodities. You'll need to choose between funds that own stocks and those with direct commodity exposure. The correlation between stocks and commodities isn't perfect, so one may rise even if the other doesn't.
• Beware of ETNs. Some inflation-fighting investments are structured as exchange-traded notes. As mere unsecured debt, ETNs leave you vulnerable to the issuer's financial situation. With so many asset-backed ETFs available, there's no reason to bear that risk.

Inflation may not be back in the immediate future, but it's likely to come eventually. Learning how to protect yourself now will leave you in a better position to handle inflation in the future.

For more on using funds and ETFs, read:

• Don't blow this great time to invest.
• The best place to find promising stocks.
• Why should you bother buying mutual funds at all?