The Amateur Financier

Today, in a very special Investing 101 column, we’re going to consider ways to help inflation-proof your portfolio.

Q: What is inflation?

A: That’s something of a complicated question.  The basic definition is that inflation is an economy-wide increase in the price of goods and services.  Remember all those stories your grandfather would tell about how milk used to cost a dime and a loaf of bread used to be a nickel?  The higher prices of those items (as well as everything else, from candy to condos) is evidence of inflation.

Q: What causes inflation, anyway?

A: In the simplest form, inflation is caused by a rising supply of money in the economy.  Think of money as a good that you can trade for other goods and services; how much money you need to trade depends on how rare it is.  If the supply of money increases relative to other goods, you will have to trade more money to obtain a particular item.  For a rather extreme example, imagine that in one year, the amount of money in the economy increases by ten percent while the supply of bread remains the same.  If the price of bread started at $1.00, then after inflation, it would cost $1.10.  This example shows an annual interest increase of 10%.

If we’re looking at the broader economy, inflation rates are usually determined by measuring the growth of a broad price index.  In the United States, the Consumer Price Index (CPI), a basket of consumer good prices, is mostly commonly used.  The average rate of increase is about 3-4% per year, which means that prices should double in about twenty years (although, a few years of higher than normal inflation could easily speed that up).

Q: What can we do about inflation?

A: On the national level, there are several possible techniques that can be used to control inflation.  Adjusting the money supply, increasing the prime rate (making it more expensive to borrow money) and, in the most extreme cases, instituting wage and price controls all have the potential to fight inflation, at least when used properly.  On the individual level, the best way to limit the troubles caused by inflation is by holding some investments that do well in inflationary conditions.

Q: Alright, what are some good investments to combat inflation?

A: The best way to deal with normal levels of inflation (the 3-4% average annual inflation rate) is to hold a diverse portfolio with a sizable portion of money in stocks or other investments that provide decent growth.  To deal with higher inflationary rates, or simply to to provide a more explicit hedge against inflation, you could consider either I-Bonds or TIPS from the US Treasury; both provide a greater investment boost when inflation runs high.

I-Bonds are similar to regular Treasuries, but the interest they pay is a combination of a fixed interest rate for the life of the bond and an adjustment for inflation that is set twice a year.  This inflation adjustment means that if inflation starts to increase greatly, so will the returns on your I-Bonds.  (As an added bonus, if you choose to hold the physical bonds, they have pictures of famous Americans such as Helen Keller and Albert Einstein (presumably, after he immigrated) on them.)

TIPS, or Treasury Inflation Protected Securities, also provide inflation protection, but do so in a different way.  They have a set interest rate, but the amount of principle in the bond fluctuates, depending on the current rate of inflation.  As a result, the amount of interest you receive during the life of the bond, as well as the amount of principle you receive at maturity, will increase along with the rate of inflation.

It’s worth noting that although both of these types of Treasuries can protect you against inflation, they are treated much differently for tax purposes.  The interest payments (and thus, tax liability) for I-Bonds can be deferred until maturity, while TIPS are taxed yearly on both the interest they yield and the ‘phantom income’ of the principle adjustments.  Because of this, it is frequently a good idea to put TIPS bonds into a tax-deferred account like an IRA, or better yet, a tax-free Roth account, to avoid such taxation.

Q: What about commodities and real estate; aren’t they good inflation hedges?

A: Somewhat.  Commodities and real estate are often considered inflation hedges because, as real, tangible items, they have intrinsic value, unconnected to their role as investments.  Assuming no change in the demand, inflation will simply mean that more money will needed to be paid for them, increasing their value along with the rising supply of money.  However, since there is no explicit connection between the returns on these investments and the rate of inflation, it’s possible that high inflation rates could cause the demand for real estate or commodities to drop, decreasing their value.  This is not to say that you shouldn’t own these investments; but think of them more as diversifying your portfolio, rather than serving as inflation hedges.

That’s it for our discussion of how to fight inflation; hopefully, you’re all a little more prepared to combat its effects on your portfolio.

Imagine for a moment that you have received $10,000.  It might be from an inheritance, it might be a bonus for outstanding work at your job, it could be winnings from a gambling trip (although, hopefully you’re not spending much of your money gambling); the source is immaterial to this particular example.  Furthermore, imagine you have two possible options for this money: you can use it pay some of your student debt, which currently has a fixed interest rate of 7% annually, or you can put the money into a diversified portfolio that should return about 10% annually.  Now for the question: which choice will leave you richer one year from now?

The correct answer, of course, is ‘I don’t know’.  It’s pretty easy to calculate the financial repercussions of paying off the debt: Cutting down $10,000 of debt with a fixed interest rate of 7% will save you from paying $700 in interest, giving you a total net worth boost of $10,700. (Actually, you will save a little more; if the debt is compounded monthly, you would have paid $723 in interest on the debt by holding it the whole year, for a real total boost of $10,723 in your net worth.)

But the stock market investment is highly variable; while you can expect a 10% return over the long term (and even that is the subject of more discussion and argument than I’m going to get into right now), in any particular year, stocks could soar, they could crash, or they could be somewhere in between.  Being able to predict how much stocks will return in any given year is a bit beyond the skills of most people; guessing a year in advance how the stock market or particular stocks will do is all but impossible.

Why do I bring all this up?  Quite simply, there’s a tendency among financial writers (myself included) to skim over the difference between fixed returns and variable returns on your investments.  Because variable returns are, well, variable, you should expect higher returns, on average, to compensate for the variability.  If stocks yielded only as much as bonds while still being more variable in their return rates, they would have ceased being a popular investment choice a long time ago.

When considering your investments, then, you need to consider both the expected investment return and the variability of that return.  When you can get a fixed return that is the same or higher than the highest reasonable return from a variable investment, you should go for the fixed return.  If the choice is between paying off credit card debt at 23% or investing in the stock market and hoping for a 10% return, the obvious choice is to pay off the debt.

If the fixed return is lower than the expected variable rate, as it frequently is, things get more complicated.  You have to consider how much of a premium will make the variable investments worth-while to you.  If you are choosing between an 8% fixed and a 10% variable return, it might not be worthwhile, while the difference between a 6% fixed and 10% variable could be worthwhile to you.  (Personally, I happen to follow the latter view, which is why I suggested paying down your debt to a level of six percent in my Ten Steps.  Now, you have a better idea of the logic behind that suggestion.)

You also have to be aware of how much risk you are willing to take in order to achieve your desired return.  It is possible to only invest in instruments with fixed rates and less rate risk, but you will have to deal with lower returns (and thus higher amounts that you need to invest).  Generally, the suggestion goes that you should take more risk in variable return vehicles when you’re younger and have time to make up your losses.  (Plus, if you have decades over which to invest, your returns should approach the averages, allowing you to treat the variable returns as close to fixed returns for your planning.)  Then you gradually shift to investments with fixed returns as you get older, so the swings in value aren’t as severe.

Hopefully, all of this helps you to get a bit of a better understanding of some of the considerations you need to look at when comparing the return rates for your investments and debts.

It’s Memorial Day here in the United States.  To all who have served (which includes both of my parents), I would like to thank you for your effort and sacrifice.  To all who have lost relatives, know that they are honored and remembered, not just today but every day.

Just a few thoughts to remember as we spend the day at picnics or with our relatives.  Please spare a thought about the reason for the special day we’ve set aside.  And, if you have some time to visit a graveyard or other memorial, I’m certain that the fallen soldiers would appreciate the time you devote to them, wherever they are now.

Happy Memorial Day.

(It’s time once again to drum up some support for deserving charities.   This time, it’s one that I’ve heard quite a bit about in various media, which focuses, interestingly enough, on fixing childhood facial deformities.  It’s an interesting mission, rather more narrow than most of the other groups we’re covered so far.  Still, that makes them no less deserving, and I think Operation Smile would be well served with some more positive press.)

Charity: Operation Smile, International

Website: www.operationsmile.org

Organization: Operation Smile is an independent 501(c)(3) organization.  Contributions are deductible from taxable income according to IRS guidelines.

Goals: Operation Smile aims to fix childhood dental deformities.  They also work more broadly to develop health care systems in underdeveloped parts of the world and work to train health care service people in those areas.

Classification: The NTEE classification on Guidestar lists Operation Smile as a Surgery, Health and Rehabilitative, and Children’s Services charity.

BBB Report:  Operation Smile meets nineteen of twenty Standards for Charity Accountability as set out by the BBB.  These standards ensure that there is adequate oversight, methods of measuring effectiveness, use most of the finances toward charitable purposes and engage in proper fund raising.

Operation Smile fails the last standard as they have more than 10% of their board members receiving compensation from the organization, leading to a potential conflict of interests.  There are also paid members with parents on the board.  The organization has said they are attempting to correct this in order to meet all the standards; in the meantime, be aware of this conflict for 6 members of the 15 member board.

Expenses: As noted by the Better Business Bureau, Operation Smile spends 23% of its budget on fund raising and 4% of its budget on administrative expenses.  It brought in $52 million dollars during 2007.

You can donate to Operation Smile here.