As the stock markets continue to recover (assuming it has not done yet), the talk of inflation is coming back in the news. Our government has pumped in so much of printed money in the system that there is a concern that US economy will experience inflationary times. There is no denying that inflation will take away chunk of our real returns from overall investing returns.

Many of the well known economists and investors (including Warren Buffett) have expressed concerns about inflation. Among all the experts and pundits, I believe, David Swensen gave a very pragmatic and down to earth response to this question in an interview on WealthTrack. According to Swensen, he does not know what will happen. He cannot predict it. There will be inflation if the recent pumping of money supports the economy and growth returns to US economy. If there is no growth, then there will be deflation of dollar value. His message was to address these issues with proper diversification and asset allocation. As individual investors what can we do to (or rather how can we) blunt the effect of inflation or deflation. Following are five aspects one can look into to manage their asset diversification.

• First, include Treasury Inflation Protected Securities (TIPS) in your portfolio. As an example, one can consider simple US Treasury based bond fund like iShares Barclays TIPs (TIP) to offset this risk. It also has low operating expenses of 0.2%.
• Second, include gold commodity as an asset in your portfolio. I believe one should hold physical gold in some form (like coins, bars, jeweler, etc). There is no point in holding those gold derivatives which can easily be manipulated. Furthermore, most of the world currencies are now completely detached from gold standard. So I would really question the notion that gold remains an inflation hedge. I tend to believe gold is an excellent hedge against any short to intermediate term crisis like currency issues, sovereignty issues, etc. It is important not to go crazy and binge on gold, but maintain an asset allocation that you are comfortable with.
• Third, include dividend paying stocks in your portfolio for companies that are doing business in commodities. These companies are able to increase prices of their products as price of raw commodities increase. Examples of such companies are ADM, EEP, KMP, BP, XOM, CLX, MCD, utilities, etc. These types of companies are less susceptible to inflationary environment.
• Fourth, include dividend paying stocks of US based or developed country multinational companies that derive significant chunk of their earnings from emerging markets. As inflation erodes dollar value, currencies from other countries can provide the fill up to their earnings.
• Fifth, include emerging market ETFs (stocks or bonds) in your portfolio. It is important to look for ETFs that are based on individual markets, denominated in local currency, and essentially captures a wider market base. The simple way to start your allocation using VWO or EEM, which are broad based. After that look for individual country ETFs. In my opinion, all those ETFs and funds that hold dollar denominated ADR and ADS does not provide hedge against the dollar inflation/deflation.

The message here is that maintaining a diversified asset allocation should be simple and easy to understand. What’s the point in investing in those confusing derivatives and linked to futures (commodity or currency) which are difficult to understand.

What is approach to this issue? How do you plan to address it in your portfolio?

This article was first published at The DIV-Net on October 1, 2009.