Inflation hedging

The fear that inflation lies around the corner seems exaggerated to me. Nevertheless, many people are worried that the Fed's quantitative easing will end in a bout of high and rising inflation. Mark Kritzman, head of Windham Capital Management and a teacher in financial engineering at MIT, recently an intriguing article about constructing inflation resistant portfolios. (He did it in the latest newsletter by Peter Bernstein, the dean of financial economists.)

What's the best portfolio to protect your savings from inflation? To answer that question Kritzman looked at the performance of 9 different assets: U.S. stocks, non-U.S. stocks, corporate bonds, government bonds, Treasury bills, commodities, gold, Treasury Inflation Protected Securities (TIPS), and real estate.

In essence, a portfolio made up of 98.77% in Treasury bills and 0.52% in commodities does an excellent job of keeping pace with inflation, he says. However, the price for that inflation hedge is no growth or no earnings premium over inflation. Most of us would like to make some money on our money.

So, Kritzman runs through different portfolios, some for conservative investors and some for more aggressive investors. What I noticed is that the key investment product is TIPS. Everything is built on top of a foundation of TIPS. For instance, for a conservative investor wanting to maximize her real returns during inflationary times about 42% of the portfolio should be in TIPS, 39% in bills, 6% in gold and 13% in real estate (I'm rounding the numbers). An aggressive investor? She'll go for 52% in TIPS, 15% in gold and 33% in real estate.

He concludes with a single portfolio that attempts to maximize growth while containing large losses. In that portfolio, 90% is in TIPS, 4% in real estate and 6% in non-U.S. stocks. TIPS are key to any of these portfolio options. The difference between an aggressive investor and a conservative one is that the former adds stock and the latter T-bills.