Rising Inflation? Protect your Investments!

Throughout your career in the life sciences, you've been socking away money, whether it's into a 401(k), a 403(b), some other IRA, a college fund, or a house. That's good. Inflation, however, can be a wolf at the door. What can you do to protect yourself? Like hindsight, judging the impact of inflation on investments is 20/20, but by that point it's often too late. The only effective way to protect your investments is to defend your portfolio early, before inflation has a chance to wreak havoc. "In the mid 1960s, for instance, people didn't see inflation coming," says Anthony Ogorek, president of Ogorek Wealth Management in Buffalo, NY. But ready or not, it came, mercilessly ravaging unprotected investment portfolios in the years ahead by consuming large doses of purchasing power. Credit: David Young-Wolff/Getty Images Even a relatively mild dose of inflation dismissed as harmless can have significant long- term effects: As the years roll on, inflation's subtle bite incessantly erodes the value of paper assets such as cash, stocks, and bonds. Those at greatest risk are investors with long-term horizons, such as middle-age parents saving for retirement or building a nest egg for sending junior to college, says Mark Kaizerman, a financial advisor who runs Kaizerman & Associates in Natick, Mass. Inflation averaged 2.7% a year for the 10 years leading up to the end of 2004, based on the US Department of Labor's consumer price index (CPI). What cost $1 in 1994 was priced at $1.27 last year; in other words, the dollar lost more than a quarter of its purchasing power in just 10 short years, and those 10 years were widely hailed as a period of low inflation. Some believe that the next 20 years aren't likely to offer a repeat of the previous 20 when it comes to inflation. One reason is the view of some economists who say that the liabilities of the United States (Social Security and Medicare payments, for instance) are rising faster than the government's ability to pay them off without printing more money, which in turn fuels higher inflation. As the general population ages and puts increasing pressure on the government for social services, the pressure to inflate our way out of the financial challenge will be ever more tempting, argues Laurence Kotlikoff, an economics professor at Boston University and coauthor of The Coming Generational Storm (MIT Press, 2005). Arguably, the future has already begun, and it doesn't look pretty. One of the smoking guns is the CPI itself. The widely monitored inflation index tracks general price trends for a number of goods and services, such as food, automobiles, and rent. In 2003, the CPI rose less than 2%. Fast forward to the October 2005 report and you'll find that consumer prices advanced at a 4.3% annual pace. The government's numbers seem to agree with other possible predictors of rises in inflation. The price of gold, for instance, has climbed nearly 75% through the end of November from the end of 2001. The precious metal is considered the classic inflation hedge, and so its bull market sends a warning sign that investors are concerned about a future rise in the cost of living. Those at greatest risk are investors with long-term horizons, such as middle-age parents saving for retirement or building a nest egg for sending junior to college, says Mark Kaizerman Commodity prices in general are also signaling higher inflation. The Commodities Research Bureau (CRB) Index is a widely quoted measure that tracks a broad mix of commodities such as corn, steel, and hogs. Since 2001, the CRB has climbed more than 64% through the end of November. Are TIPS for you? Investing in Treasury Inflation Protected Securities (TIPS) is one widely held defense against the risk of rising inflation. TIPS are issued by the United States Treasury, and so they come with the same assurances that back standard Treasury bonds. But, they also carry a bonus: TIPS hedge any inflation risk that otherwise might devalue a conventional Treasury bond's purchasing power. The TIPS hedge draws power from a yield that adjusts with inflation. If inflation rises, so too does the TIPS yield, which is adjusted based on changes in the CPI. That compares with a conventional Treasury bond, whose yield is constant regardless of inflationary winds. Although a regular Treasury bond usually offers a higher yield over its TIPS counterpart, the premium comes at a price. Indeed, the standard-issue yield is set in stone for the life of the bond, which would be a losing proposition over time if inflation rises high enough and eats away at the purchasing power of the yield payments. TIPS, however, would keep pace, even though its yield started at a lower point. Of course, if inflation declines, the conventional Treasury bond will likely prove the better investment over its inflation protected sibling. So the question of investing in TIPS and how much to invest often comes down to timing. Financial planner Richard Ferri, president of Portfolio Solutions in Troy, Mich., offers a simple rule of thumb that boils down to comparing yields on regular Treasuries vs. TIPS (interest rates statistics can be found at the Treasury's Web site, www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/index.html). "I don't make guesstimates. I look at the markets and then choose the more attractive payout," says Ferri. For example, when the yield premium, or spread, in regular Treasuries was approaching three percentage points over TIPS in late 2004 through the first half of 2005, Ferri says he was buying the conventional securities. At 2004'\s close, for instance, the conventional 20-year Treasury yield was 4.85% vs. 1.96% for the 20-year TIPS. The premium in standard Treasuries, he reasoned, was sufficient compensation against any future inflation threat. But when the spread narrowed to roughly two percentage points by late summer and early fall of 2005, he was selling regular Treasuries and buying TIPS. Ferri says he maintains an ongoing allocation of TIPS in client portfolios of as much as 10%. How much of your investment portfolio is in TIPS? jpicerno@the-scientist.com Biotech hazards You work in the life sciences, so you figure you should invest in biotech. The numbers seem to support you: the topperforming mutual fund specializing in biotech in the past three years, Profunds Ultra Biotech, posted a 29.1% average annual total return through Oct. 31, 2005, according to Morningstar, the Chicago fund-analysis firm. Compare that with the Dow Jones Industrial Average, which managed a relatively tepid 10% per year over the same stretch. But that doesn't mean you should invest heavily in biotech, warns Christopher Jones, a financial planner with Keystone Financial Planning in Easton, Pa. "You're already exposed to it in your career," says Jones. Your salary and prospects, in other words, are heavily dependent on the industry's fate, and in the short run, at least, that fate can be volatile: in 2002, Profunds Ultra Biotech lost more than 50% before rebounding. As history clearly shows, ignoring the benefits of diversification is all too often a prescription for trouble. Diversify, Diversify, Diversify Owning treasury inflation protected securities (TIPs) is arguably the first line of defense for buying something akin to an insurance policy that will kick in if inflation rises. But history also suggests that a combination of investment instruments can best help guard against losses due to inflation. "Over time, owning stocks is the way to preserve long-term purchasing power," says James Reilly, a financial advisor at regent atlantic capital in Chatham, NJ. The historical record says as much. From the end of 1925 through the close of October 2005, the stock market posted an average annual total return of 10.3%, measured by the S&P 500, an index of America's largest publicly traded companies. Standard-issue 20-year treasury bonds paled by comparison over those decades, earning only 5.4% a year, or just ahead of inflation. Anyone can buy into corporate America's earnings growth with a low-cost index fund such as the Vanguard 500. Financial planner Anthony Ogorek, president of Ogorek Wealth Management in Buffalo, NY, recommends owning a mix of equities, real estate, bonds, commodities, and cash, all of which are available through mutual funds. Real estate mutual funds target real estate investment trusts, or companies that own and operate various types of commercial properties. A number of mutual funds target both treasuries (regular or TIPs) and corporate bonds. Alternatively, you can buy government securities directly from the US Department of the Treasury at www.treasuryDirect.gov. A broad portfolio of commodities can be found in a relatively new class of mutual funds, such as the Oppenheimer Real Asset Fund and Pimco Commodity Real Return Strategy Fund. There are also mutual funds that invest in treasury and high-quality corporate debt securities that come due in less than one year.

Rising Inflation? Protect your Investments!

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James Picerno

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January 2006

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