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John Waggoner's personal investing column in today's USA Today focuses on building a portfolio to protect against the inflation that, it seems to me, is likely to build up dramatically over the next few years. He highlights four inflation hedges:

  • Dividend-paying stocks
  • Gold
  • TIPS
  • REITs

I've done my own research on those assets plus commodities as inflation hedges, so I can add a little color to Waggoner's recommendations.

(1) Waggoner doesn't actually recommend gold, and that's good -- because gold, it turns out, has historically been a terrible inflation hedge.

(2) Equity REITs have historically provided the best inflation hedge.

(3) Commodity returns -- as measured by the GSCI -- are second only to equity REITs, but that's because energy prices dominate the GSCI. Returns measured by the GSCI Non-Energy Index are significantly weaker as an inflation hedge.

(4) TIPS aren't actually very good as an inflation hedge, even though their principal adjusts automatically to the CPI. But there's a big caveat there: TIPS started trading only in 1997, so to look at their performance during inflationary times (such as the late 1970s and early 1980s) I used a synthetic TIPS return series generated by Ibbotson Associates. Ibbotson really knows what they're doing, but if their "returns" are off, then that could throw off the analysis.

(5) Stocks actually perform slightly better than TIPS in terms of hedging inflation.

Here's how my analysis works. First, TIPS adjust to the CPI only every six months, so if we're going to evaluate them as an inflation hedge then we have to look at (overlapping) six-month periods. Second, for inflation-hedging purposes we don't care what happened when inflation was low (or negative), so I restrict the analysis to six-month periods during which inflation was relatively high: 3.4% on an annualized basis, which is the median during the historical period since 1973. Finally, the critical question is whether a given asset protects purchasing power, so I count how frequently each asset's total returns equal (or exceed) the inflation during those six-month periods of relatively high inflation. Here are the results:

  • Equity REITs: 66.2%
  • Commodities (GSCI): 65.3%
  • Stocks (DJ Total Market): 58.3%
  • TIPS (Ibbotson): 56.9%
  • Non-Energy Commodities: 56.0%
  • Bonds (BC US Agg): 50.0% (since 1975)
  • Gold: 41.1% (since 1977)

A portfolio that's well hedged against inflation will probably have significant exposure to three of the four assets that Waggoner focuses on -- REITs, TIPS, and stocks -- along with energy-related commodities.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Author is long Vanguard REIT Index Fund and ING Real Estate Fund

Disclaimer: The opinions expressed in this post are my own and do not necessarily reflect those of the National Association of Real Estate Investment Trusts ((NAREIT)). Neither I nor NAREIT are acting as an investment advisor, investment fiduciary, broker, dealer or other market participant, nor is any offer or solicitation to buy or sell any security investment being made. This information is solely educational in nature and not intended to serve as the primary basis for any investment decision.