Seven Ways to Beat Inflation

Original Post: http://blogs.forbes.com/baldwin/2011/03/01/seven-ways-to-beat-inflation/
William Baldwin Mar. 1 2011 - 8:40 am for Forbes.com

Non-fiat money; image via Wikipedia

The cost of living could double over the next decade or two. What are you going to do about it?


If you are young and still in the workforce, your best defense is your talent. Wages tend to keep up with inflation, at least over long periods. If you are retired, you’ve got only your balance sheet to lean on.

In this report I’ll look at seven strategic moves for combating the Consumer Price Index. Companion pieces will take up fixed-income investing (with six inflation-fighting ideas) and how to own commodities (five ways).

In all, there are 18 inflation fighters you should know about. That doesn’t mean you should adopt them all. Some are too speculative or expensive for everyday use. One, in the commodity section, goes in the category of Downright Stupid.

Inflation is, deservedly, retirees’ second biggest source of anxiety (after health). They are old enough to remember the 1970s, when the prices of everything went through the roof. Everything except bonds, that is. Bond portfolios were massacred.

It’s something I think about every day. I own a lot of bonds.

Officially, inflation is quite tame at the moment, which is how the Federal Reserve justifies its printing press (now running off fiat money at the rate of $20,000 a second). Chairman Ben S. Bernanke reassures us that prices aren’t going up much, if you don’t count food or energy.

This reminds me of a classic remark from a long since diselected mayor of Washington, D.C.: Our crime rate isn’t all that bad, he said, if you don’t count the murders.

Here are seven strategies for beating inflation. In all likelihood, you already have some of these in place. You don’t have to be terrified by the CPI.

Own real estate

Over long periods, home prices more than keep up with the price of living. The real price gain (appreciation net of inflation) has averaged something like 1% a year over the past century.

The suburban home I grew up in appreciated at a 6% annual rate between the time my parents bought it in 1953 and its recent sale. This, despite the recent real estate crash and despite the fact that the house was poorly maintained. After inflation: 3% a year.

The housing crash isn’t quite over, but I think we’re pretty close to a bottom. I’m pretty confident that if the CPI triples in the next 20 years, home prices will at least triple.

Your strategy here, if you just retired, would be to postpone downsizing. It’s a reasonable alternative to more-complicated inflation fighting strategies, especially if you have other reasons for staying put.

Own stocks

A stock is a share in a business that probably owns at least some hard assets and has some prospects for increasing its prices as the dollar falls in value.

To be sure, a surge in inflation can hurt stocks for a while. Stocks got killed after the 1973 Arab oil embargo sent the CPI on an upward spiral. But over long periods, stocks beat inflation. Over the past century they have earned 6% a year, above and beyond inflation, when you include dividends.

Owning shares enabled investors to survive inflation in Brazil and Mexico. It has enabled U.S. investors to survive the Great Inflation that began in 1971, when the dollar was unhinged from gold. Since then prices have more than quintupled. Nonetheless, U.S. stocks have delivered a real annual total return in the past 40 years near their 6% long-run average.

At the moment, U.S. stocks are richly priced in relation to corporate earnings, so I expect only 5% a year, net of inflation, over the next 40 years. Still, stocks’ resilience to CPI creep makes them an important part of a retiree’s portfolio.

Put at least a third of your investable assets in equities. Put in more if you don’t own a home. Put in more if you have enough slack in your budget to tolerate some wild swings in your net worth.

The cheap, easy way to own stocks is through an exchange traded fund or open-end mutual fund tracking an index. Index funds for the S&P 500 cost 0.1% of assets per year, or thereabouts.

Own resource funds

You get a concentrated dose of inflation hedging by owning shares in companies that dig stuff out of the ground.

The T. Rowe Price New Era Fund has delivered handsome returns over the past decade by owning resource sector companies like Schlumberger, Cameron International and Freeport-McMoran Copper & Gold. This fund is very affordable, at a fee of 0.67% of assets annually.

Cheaper still, but without the active management, are two exchange traded funds from Vanguard, covering the materials and energy sectors. The portfolio of the materials fund (ticker: VAW) starts with Freeport-McMoran, Du Pont and Dow. The energy ETF (ticker: VDE) has Exxon Mobil, Schlumberger and Chevron as its largest positions. Both of these funds cost 0.24% annually.

If you are putting in $100,000 or more, you can get either of these Vanguard sector funds in the open end (mutual fund) format. The open end funds have no sales loads but penalize short-term holders with a 2% redemption fee. The expense ratio is the same.

Whatever their net worth, investors desiring Vanguard sector funds in their taxable accounts are better off with the ETFs. You can trade in and out of an ETF as often as you like, incurring only your online brokerage fee ($9 or less) and a bid/ask spread (a few pennies a share). With this flexibility you can harvest tax losses.

Vanguard also has a Precious Metals fund. This one is not available as an ETF. It has one of those sanctimonious redemption fees that get in the way of loss harvesting.

Own resource stocks

You don’t have to pay a fund company to hold stocks for you. Hold them yourself. You’ll eliminate that management fee. Instead of putting $100,000 into a fund, copycat ten of its positions at $10,000 each. Savings: $240 to $670 a year.

Your transaction costs for à la carte investing won’t be much higher than for the ETFs, and indeed may be a bit lower. Shares of big companies like Exxon trade at narrower bid/ask spreads than do the ETFs that hold them.

Include in your mix energy, fertilizer, gold and timber companies. For gold exposure, Newmont Mining is the obvious choice, but you’ll find some intriguing, if flaky, alternatives by taking a peek at Vanguard’s Precious Metals sector fund.

Weyerhaeuser is the big timber holder. It is now converting into a real estate investment trust in order to eliminate corporate taxes.

Buy REITs

Apart from some timber companies (see preceding paragraph), the REIT industry consists primarily of landlords. REITs own office buildings, malls, apartments, warehouses and storage cubicles. The inflation hedge: Landlords jack up rents to match the cost of living.

Tread lightly here. REIT prices have doubled in the past two years. That means your dividend yield is half what it was. It also means that, even if your dividend keeps up with the cost of living, your share price will struggle to do so.

Delay Social Security

Are you (a) in good health and (b) financially comfortable? If so, then it may make sense for you to delay starting your Social Security payments. By doing so you earn a fatter monthly check, and this check is inflation-protected.

Whether it’s best to start drawing at 62 or 66 or 70 is a complicated question. Often, it makes sense in a two-earner couple for one member to start at 66 and the other at 70. Read more about the strategy here.

I’ll add one point to the usual actuarial analysis. Social Security is a bankrupt Ponzi scheme. One way to make it more solvent would be to reduce the inflation escalator for prosperous retirees. This outcome is not highly likely, but it’s more likely than any reform that involves confiscating benefits already paid.

By not taking $100,000 in benefits from 66 to 69 you buy an inflation-indexed annuity starting at age 70. You thought you were buying a CPI-indexed supplemental annuity. After you start collecting it turns into a CPI-1% indexed supplemental annuity. You might have been better off taking the 100K and investing in the stock market.

In short, if you are on the fence, and you are what President Obama considers rich, start at 66 rather than 70.

Owe money

If you are retired, your mortgage should be paid off. But if you are younger it may make sense to owe money. To the extent you owe money you get a windfall from unexpected inflation. That’s because you pay off your creditor with cheapened dollars.

Suppose you are 40 and owe $500,000 on your fixed-rate mortgage. And suppose you have $500,000 in a tax-sheltered retirement account, invested in Ginnie Mae funds. In these circumstances, you can sleep at night. Inflation can’t hurt you very much.

Why? A run-up in inflation will raise interest rates and that will cause your Ginnie Maes to lose value. But it will also, over time, make your home’s value higher than it would otherwise have been, while your mortgage debt remains frozen. So you’ll wind up with more home equity than you otherwise would have had.

I’m not advocating willy-nilly borrowing, only a holistic approach to your balance sheet. If you are young and mortgage heavy, you are not as vulnerable to inflation as you may think. You can lighten up on the timber and gold stocks.