Strategies for dealing with inflation risk

Worries about rising inflation have spooked stock and bond investors. As a reminder, inflation occurs when the prices of goods and services rise, and as a result every dollar you spend in the economy purchases less.

The annual rate of inflation from 1917 until 2017 has averaged just over 3 percent annually. That might not sound like much, but consider this: Today you need $7,272 to buy what $1,000 could get you 50 years ago.

It has been a long time since the double-digit rates of 1979-1980. Inflation has hovered just above 2 percent over the past 20 years, despite repeated warnings that the Federal Reserve’s intervention during the financial crisis and its aftermath would spark a surge in prices. The relatively tepid recovery, combined with an aging population and technological advances, kept a lid on overall prices.

And while there have been periodic surges in prices over the past nine years, the most recent inflation alarm bells went off on Feb. 2, when data showed that hourly wages had jumped by 2.9 percent in January from a year ago.

As of January, the government’s measure of inflation, the Consumer Price Index, had increased 2.1 percent over the last 12 months (1.8 percent without food or energy costs included). But as the global economy improves and U.S. tax cuts spur more spending, many believe that the era of low inflation is probably behind us.

So how should you adapt to the new economic order? One easy way is to lock in fixed-rate mortgages. Borrowing for the long term is still historically cheap. If you are refinancing, you may want to fold in home equity loans or credit card debts that are tied to variable, short-term interest rates.

As far as investments, your goal is to grow your portfolio at a quicker pace than the rate of inflation while keeping focused on the level of risk you are willing to assume. While no single asset acts as a perfect inflation hedge, consider the following:

--Commodities: When inflation rises, the price of commodities such as gold, oil, food and raw materials also increases. However, this is a volatile asset class that can stagnate or, worse, lose money over long stretches of time. Therefore, investors would be wise to limit commodity exposure to 3 percent to 6 percent of total portfolio value.

--Real estate investment trusts (REITs): The ultimate “real asset,” REITs tend to perform well during inflationary periods, due to rising property values and rents.

--Stocks: Many investors don’t think about stocks as an asset class to combat inflation, but long-term data show that stocks, especially dividend-producing stocks, tend to perform well in inflationary periods. That said, during short-term inflationary spikes, the stocks might drop before reverting to the longer-term trend.

--Treasury inflation-protected securities (TIPS): Rising prices can diminish a bond’s fixed-income return. But the U.S. government directly offers investors inflation-indexed bonds, or TIPS, which proved a fixed interest rate above the rate of inflation, as measured by the CPI.

--International bonds: Inflation can shred the value of the U.S. dollar, so consider a small allocation to international bonds, which are denominated in foreign currencies.

While inflation may be looming, it’s important to underscore that a diversified portfolio, which takes into account your time horizon and risk tolerance, will go a long way toward protecting. If you are worried about inflation, the other asset classes should be used sparingly to round out your overall allocation.