How Should I Safely Diversify to Beat Inflation?

By Dr. Don Taylor, Ph.D., CFA,

Dear Dr. Don, I am not diversified, and I'm close to 80. Is money in the bank or a credit union, which is protected by the Federal Deposit Insurance Corp. and private insurance, OK for now? My thoughts are that inflation is on its way, and where else could I diversify to where the principal is not vulnerable?

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Thank you. -- Philip Principal

Dear Philip, People tend to be more diversified than they think they are because they don't look at the big picture. I expect that you're only considering how your financial securities are invested. We typically categorize these investments as stocks, bonds or cash, with cash being financial shorthand for short-term liquid money market investments. That would include bank savings accounts but not long-term certificates of deposit, which I would classify as bonds.

If you're receiving Social Security, you're getting an income stream that compares to an inflation-indexed fixed-income annuity. Getting a pension? There's another fixed-income annuity. If you own your personal residence, you are invested in real estate.

With all that said, you could still need to diversify your investments. My worry is you're concerned about future inflation, but your focus is on protecting principal. Investors seeking safety of principal in federally insured bank accounts can find it -- but that won't do much to protect those deposits from having their purchasing power decline due to inflation.

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    The government guarantees that back deposits and shares insured by the FDIC and the National Credit Union Share Insurance Fund, or NCUSIF, will always trump the guarantees offered by a private insurer because the government can do something the insurers can't -- tax the populace. Private deposit insurance is available from many financial institutions to provide coverage beyond FDIC and NCUSIF limits, but there's also the Certificate of Deposit Account Registry Service, or CDARS, which allows you to have multimillion-dollar FDIC insurance coverage with one deposit relationship from a participating bank.

    At today's prices, I don't recommend U.S. Treasury inflation-protected securities, or TIPS, as a method of protecting your portfolio against inflation. These securities have been bid up in price to the point where the yields on the shorter maturities are less than the inflation rate, and the longer maturities offer yields of less than 1% plus inflation. At some point, the music has to stop, and the price risk in these securities can be substantial, even though the TIPS' inflation-indexed face value is guaranteed by the U.S. government.

    Series I savings bonds don't have the price risk inherent in TIPS, but you can only buy $5,000 in face value each year -- unless you buy them with your tax refund money. Still, a current purchase offers you just inflation protection with no fixed yield above the inflation rate.

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