Inflation risk can hurt portfolio that plays it too safe

Inflation risk can hurt portfolio that plays it too safe
By Matt Krantz, USA TODAY

Q: Can being too safe with your investments, by putting a large chunk in savings, be in fact risky if there’s inflation?

A: Being too safe can be a sure way to lose money.

Due to the potential ravages of inflation, one of the most certain ways to see the power of your portfolio erode is by taking no risk and getting no return. This is a difficult lesson for many beginning investors to learn and a painful one for older investors too suffer from, often when it’s too late.

Here’s why. Due to inflation, the value of your paper money erodes by about 2.5% a year. That means the one dollar bill in your hand today will only be worth the equivalent of 97.5 cents a year from now. That might not sound like much of a loss, but the erosion of inflation can be brutal over long periods of time.

Imagine a person who buries $1 million in their backyard. In thirty years, those one million dollar bills will still be in the earth. But the purchasing power will be greatly reduced. Even if there’s just 2.5% annual inflation, that $1 million will buy less than half of what it would have bought 30 years prior.

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And it’s this brutal attribute of inflation that is why you’re precisely correct. By taking no risk, and simply hanging onto the money you have now, you are exposing yourself to a pretty good shot of losing 2.5% of your money’s value, if not more, over time.

Certainly, there are low-risk options to deal with this. You can reduce your annual inflation hit by putting a chunk of your money into a high-yield savings account, generating interest currently of about 1.2%. But again, that’s not enough to keep up with inflation.

Keeping up with inflation requires you to take additional risk. There are many ways to try to deal with inflation, though. A growing number of retirees are keeping at least a portion of their portfolios in stocks, as the potential price appreciation and growing dividends are a way to combat inflation. But with that higher percentage of stocks comes greater risk of loss and volatility.

And that’s where the search to combat inflation has become practically a national pastime. Some are turning to investment products offered by insurance companies, called annuities, which pay retirees a certain amount of money each month. Some of these contracts can be adjusted so the payments rise with inflation. These, though, come with the added caveats of fees and sometimes onerous conditions and a lower interest rate.

Others are considering Treasury Inflation-Protected Securities, or TIPS, which are Treasuries that adjust the principal upwards if there’s inflation. These investments, though, can turn out to be poor choices if inflation doesn’t materialize as feared or if inflation is in reality greater than the way the government calculates it.

Another strategy, which is increasingly popular, is investing in precious metals like gold and silver. The idea is that these metals will hang onto their value no matter what happens to government issued currencies. While investments in precious metals have been stellar the past years, historically these can be highly volatile investments and short-term price swings can easily exceed those of stocks and bonds.

As you can see, you’re right. Doing nothing does incur inflation risk. Unfortunately, the answer to the problem isn’t all that simple. Perhaps one strategy would be to spread your risk around by adding stocks, perhaps considering an annuity, evaluating TIPs or maybe considering precious metals.

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Inflation risk can hurt portfolio that plays it too safe