Protect Your Investment from Inflation

No matter what kind of investment vehicle is chosen, the return is always subject to changes with the inflation rate, and would lose its buying power even if the amount of the return might seem higher. What this means is what a return would buy when it is earned is always reduced unless something is done about it. It is not possible to buy the same amount of goods and services with any given return in a current year at a similar level with a previous year. The reason for that is the price of goods and services will always rise even if it would not be at a similar rate, because the external factors that will affect the price increase of various products are different. If the price of oil had been, more or less, stable in a given year, it is possible that the rate of inflation would also be moderate if not nonexistent, because there are other factors that affect the price of goods and services.

The concern of the investor, however, is to protect the involved investment in whatever form it is from this phenomenon that renders an investment effort futile, because after waiting for a full year if the money generated is going to buy less than what the invested money used to buy the previous year, it might not be worth the effort. The good thing about it is there are numerous available mechanisms to protect investment returns from being eroded out of proportion, which means a good portion of their buying power will remain intact no matter how high the inflation rate is.

Usually what investors worry about is the nominal return on their investment, simply because they do not know what the real return is going to be since there is no mechanism to predict what the inflation rate will be. To combat this uncertainty, the most common method used by investors is to increase the risk-adjusted return of a portfolio. What this refers to is the level of the risk a portfolio takes to earn its returns. Attaining this goal requires investing for the most part, in fixed-income securities and equity. In addition, there is another asset class that is our focus here that will add diversification to a portfolio, without costing much or without requiring extra effort.

It was in the early 1980s inflation-protected securities (IPS) came into existence in the markets and since then, they had become a proven way of protecting a return from inflation. The key here is securities that are IPS have two payment systems. The first one is the nominal return, which is what the instrument comes with and known in advance, and the second payment is the real return that will be adjusted for inflation, protecting the return from whatever inflation has occurred throughout the involved investment period. What differentiates securities that are not inflation-protected and those that are inflation-protected is the "real return" offered for IPS and the "nominal return" offered for normal securities in comparison to the inflation rate that would be involved for the given duration. There is a given point known as the break-even inflation rate that could be high or low, which means IPS will not always stand to give a better return, since that is determined by the rate of inflation that will not be known until the involved duration is over.

Consequently, historically IPS had been covering returns from being eroded because inflation rates vary depending on the involved markets, but there are not many markets that are immune from the effect of inflation, except that the degree of the damage could be according to the rate of a particular market's inflation. Like it was mentioned earlier, a portfolio is much better off if it is made up of such a failsafe mechanism the will cushion the effect of the real return that is always unpredictable.

There are a number of IPS in the market that are worth knowing about, because any investment portfolio without the hedge they provide will have its buying power eroded with the exact amount of the inflation rate that could be high if the investment is held for a long period that involves more than ten years. To avoid this, when buying Treasury Bills, looking for Treasury Inflation-Protected Securities (TIPS) will hedge the erosion that will occur because of inflation. However, one key aspect of TIPS to be aware of is the amount of interest they pay is less because of the security advantage they avail for investors and they certainly would cost more for whoever is issuing them.

There are also Municipal and Corporate Inflation_Linked Securities where the municipal bonds are issued by various governments. The only difference is their interest rate payment is less than the regular bonds or Treasury bonds, but if there is an advantage they avail it is that their payments change with the consumer price index, which is where the rate of the inflation is derived form. The way this process works is there will be a package of goods that have a high demand put in a basket and their price change will be monitored to surmise what the effect of inflation on them will be.

The same applies to corporate inflation-linked securities offered by corporations that sell for as low as $1000 and they give a yield adjusted for inflation. The advantage with this particular securities is their yield is much higher simply because they are risky as there is nothing guaranteeing them other than the credit rating and performance of the issuers. However, when they give return there is a much better payoff when seen form the others' standard if they are inflation-linked.

The other ones are Inflation-Linked Certificate of Deposit (CD) that are insured up to $100,000 and are mostly offered by banks or through banks as a short-term loan and could start from $1000. They get the exact treatment they deserve as short-term finical instruments that range from a few months to a few years. The yield they avail will be covered from inflation and because of that what they pay is not the same with normal CDs that are not adjusted for inflation that pay higher real yield. There are also savings bonds that use the same method to cover what they pay out in a form of interest from inflation and they are among the safest securities.

The Inflation-Linked savings bonds that are offered by the government are very safe securities and have an added advantage because it is not required to pay income tax on their return, but they give a lower return when compared with the other securities. Historically, real returns had always been vulnerable to inflation and this is truer when especially the duration of the investment is longer. For the most part, IPS are recommended for long-term investments and even if they are similar with fixed income assets, in real term they are not since inflation cannot erode their real return that is covered by IPS. However, IPS might have a few disadvantages such as the accrued interest is taxed immediately and to avoid that they require to be held within a tax sheltered portfolio.

The conclusion is even if fixed income securities issued by various governments are very safe, it is not possible to safeguard their return from the menacing of inflation that will bring down their buying power. Consequently, choosing inflation-linked securities could fend off the erosion of their buying power. However, it is difficult to say they are always a better bet than buying the not inflation-linked ones, because since they offer a higher rate of return if the rate of inflation had been low for the duration involved what they will offer will be high. Nevertheless, historically there had always been some rate of increase in inflation, the reason why they are unavoidable choice to build a balanced portfolio.