It's no secret that inflation is a hot topic in today's investing community. As gas prices rise and certain food items become more expensive, a lot of folks are worried that a spell of runaway inflation is right around the corner. After all, the accommodative monetary policy the U.S. has been pursuing in recent years appears to be setting the stage for inflation to take off as soon as it can get a firm grip on our economy.
But while investors definitely don't need to hit the inflation panic button, they should prepare for the possibility of rising prices. Fortunately, there are steps any investors can take to shield his or her portfolio from the threat of rising prices using some of the cheapest investment vehicles around -- exchange-traded funds.
A life jacket for bonds
Inflation is damaging because it erodes consumer purchasing power, a special concern for investors in or close to retirement. So if you've got a hefty portion of your assets in bonds or bond funds, maintaining your buying power should be a primary goal. If you're about a decade out from retirement, you may want anywhere from 15%-25% of your bond holdings in inflation-protected securities. If you're already retired, you may want to bump this allocation up to 30%-40% of your total bond exposure. Fortunately, there are a number of ETFs that provide easy exposure to inflation-indexed securities.
One of the most popular is the iShares Barclays TIPS Bond ETF (NYSE: TIP). For a low 0.20% price of admission, investors can get access to a bond fund that invests in Treasury Inflation-Protected Securities, whose coupon payments and principal are adjusted to rise with inflation (and fall with deflation). Two other newer and slightly lower-cost options that do the same job are SPDR Barclays Capital TIPS (NYSE: IPE) with its 0.18% price tag and Schwab U.S. TIPS ETF (NYSE: SCHP), which will set you back 0.14%.
Dangerous waters
Commodities have been the market's darling in recent history, and given the eye-popping returns that precious metals and energy-related stocks have posted recently, it is little wonder why. Traditional wisdom has always held that commodities such as gold provide a solid hedge against inflation. And while I wouldn't bank on gold being a perfect inflation-hedging instrument, it can provide your portfolio with an additional layer of diversification. The same idea applies to a broader basket of commodities.
While a small commodities allocation (no more than 5%-8%) can make sense over the long run, investors diving in now are facing some heightened risks. Don't buy into this sector now if you're not willing to stomach some potential drops in the near term. If the high price of gold doesn't scare you off, you can add some exposure to your portfolio on the cheap with SPDR Gold Shares (NYSE: GLD).
If you're looking for broader exposure to the commodities markets, you'll want an ETF that tracks a wider range of investments such as crude oil, natural gas, silver, aluminum, wheat, and sugar. Here, a good choice is the PowerShares DB Commodity Index Tracking ETF (NYSE: DBC). And while the fund isn't cheap by ETF standards, clocking in at 0.85%, you'll pay a lot less here for broad commodity market coverage than you would with practically any actively managed mutual fund. Just keep in mind that by getting into commodities now, you may be playing with fire.
The forgotten inflation hedge
Of course there is one investment that has proven to be a very effective long-term hedge against inflation: regular old stocks. Since the goal is to earn returns in excess of inflation, you want investments that can offer you the greatest long-term rewards. Despite the two bear markets that the new millennium has brought us so far, stocks still have an excellent track record over the long run. And if you've still got a decade or more until you retire, the long term is what you should be focused on.
One of the most comprehensive and inexpensive domestic stock market ETFs around is the Vanguard Total Stock Market ETF (NYSE: VTI). For a rock-bottom 0.07% annual fee, investors can gain exposure to thousands of domestic stocks of all sizes, although the fund leans more heavily into large- and mid-cap territory. And since you don't want to ignore all the investing opportunities outside of U.S. borders, you've got to have some foreign exposure as well. If you want a fund that covers the widest swath of international markets, check out the Vanguard Total International Stock Index ETF (NYSE: VXUS), which tracks the performance of foreign stocks across the entire globe, from both developed and emerging nations. Remember that while Wall Street may dangle fancy-looking inflation-fighting products in front of you, owning stocks is still one of the best ways to beat inflation over the years.
Ultimately, time will tell how much of a problem inflation will become in the near future. So while you don't need to load up on canned food and ammunition, you should be prepared for a slightly more inflationary environment. Fortunately, by making a few minor adjustments to your portfolio, you can be ready for any level of inflation that may be heading our way.
