According to Wharton insurance and risk management professor Kent Smetters, inflation destroys the value [of investments] gradually by eroding real returns over time. In the first installment of a new personal finance column for Knowledge@Wharton, Smetters discusses how investors can guard their portfolios against surges in inflation.

Which decade witnessed the largest stock market decline in U.S. history? The decade starting with the Great Depression? The Panic of 1987? The most recent decade with its two crashes? After adjusting for inflation, it turns out that the 1970s was the worst. While the Great Depression produced the largest nominal percent point drop, it also generated a period of deflation. So there were fewer dollars to spend, but each dollar retained bought you more bananas. Total real purchasing power was only reduced by about 45%. In contrast, the OPEC crisis during the 1970s, along with its double-digit inflation, reduced purchasing power by almost 50%.

Indeed, one of the biggest threats to your portfolio's performance over time is inflation. For every additional point of inflation, your portfolio will lose about 20% of its purchasing power over the next 25 years. In addition, taxes are levied on your portfolio's nominal return, even if it does not experience a real increase in purchasing power. All combined, you can easily lose a third or more of the value of your portfolio over time with just a tiny bit of extra inflation.

Moreover, unlike jarring market crashes -- such as the Great Depression or the recent crisis -- inflation lurks in the shadows. It destroys value by gradually eroding real returns over time. It is financial death by a thousand cuts. Investors too often look at the numbers in their portfolio without asking what those numbers can actually buy over time. It's a classic mistake that John Maynard Keynes termed money illusion.

But there are two good reasons to now start paying close attention to inflation again. First, the expansion of the Federal Reserve's money supply during the past 18 months has been enormous and unprecedented. As Milton Friedman most clearly articulated decades ago, more money chasing the same number of goods usually generates higher prices. In fact, had the recent monetary explosion happened during normal times, prices would have likely doubled. Second, projected federal deficits are ballooning out of control. According to the Congressional Budget Office, the new Obama Budget will add almost $9.8 trillion to the national debt over the next decade. Astonishingly, the market has even recently priced some corporate bonds as safer than government securities. Eventually, it will be too tempting to reduce the value of this snowballing debt simply by printing more money.

Inflation hawks have now begun circling. Some investment advisors are urging their clients to buy gold and other commodities in order to maintain purchasing power as the value of the dollar shrinks. But these hawks are no longer just located in the outer circles. At a recent FOMC meeting, the Kansas City Federal Reserve's president broke ranks with the rest of the members by voting against the continued era of cheap money. Even the Chinese government, who now holds almost 10% of U.S. debt, has expressed a desire for a new currency to replace the U.S. dollar as the world's benchmark, although concerns about a massive Chinese selloff of dollars are likely overblown.

To be sure, recent core inflation numbers (that exclude volatile food and energy) have been well below expectations. Given the severity of the economic slump, many experts believe that low inflation will continue for a while. In March, the presidents of the regional Federal Reserve banks in Chicago and St. Louis called for continued accommodative monetary policy, which is just code language for more of the same loose controls on the money supply. Opinion pieces in the Wall Street Journal and New York Times have even argued that the deficit hawks should simply go away.

For investors, however, the current debate over the inflation outlook is incomplete and misleading. Diversified investors hold many types of assets. Some of these investments are more sensitive to inflation over the short run while some are more sensitive over the long run. Both time horizons should matter to investors.

In the short run -- say over the next three years -- inflation is likely to continue to be quite low. One reason is that explosive growth in the Federal Reserve's balance sheet has been mostly matched by enormous increases in excess reserves held by commercial banks despite a very steep yield curve. In other words, the banks are hoarding the cash, preventing it from becoming part of everyday transactions. Why? One reason that is the Federal Reserve now pays banks interest to encourage them to hold additional reserves. Some banks also fear that rising short-term interest rates will increase their costs over the life of the loan. (Their fears are indeed reflected in prices of one-year futures contracts for Fed Funds.) More importantly, the banking sector is just in Phase One of the residential real estate mortgage crisis, the so-called subprime mess. Phase Two -- defaults of Alt A types of residential loans that were often issued to sole proprietors with less formal income documentation -- will begin later this year. Phase Three -- defaults of Option ARM loans in which interest rates sharply increase a few years after the loans start -- will begin to increase next year. Banks need to reserve against all of these potential losses.

Of course, if banks happen to be over-reserving for these losses, then inflation might come sooner if the Fed can't quickly yank money out of the banking system. But that scenario is unlikely. Indeed, Phase Four of the mortgage crisis -- this one stemming from the commercial lending side -- has received very little attention this far. If anything, banks are probably still not reserving enough for these defaults. Combined with the recent economic slowdown in Europe, it is likely that inflation will be held in check for a while.

But longer-run inflation (beyond five years) should be on everyone's radar screen. In fact, it is unlikely that the current yields on 30-year Treasury securities will be enough to cover inflation over time, much less provide a real return. Present value shortfalls in Social Security and Medicare are in excess of $70 trillion and will likely lead to an inflation tax. Yields on 10-year Treasury securities -- which policymakers try to keep low because of their indirect relationship to mortgages -- may not be high enough to cover inflation.

So what is an investor to do about inflation? The traditional choice is to invest in commodities, metals, oil and the like. The broadest investible measure of commodities is almost 85% correlated with the Consumer Price Index (CPI) on an annual basis, meaning that the value of commodities tends to move in the same direction as inflation. Gold is almost 60% correlated, oil stands at 21%, and real estate and natural gas are both at 5%.

But, contrary to conventional wisdom, none of these asset classes are actually good inflation hedges anymore. They are already too popular.

Indeed, don't be fooled by correlation. Two data series can appear to be highly correlated even though one of them consistently underperforms the other. In fact, commodities are about the only major asset class that actually underperforms the CPI over time. More targeted sector plays -- such as gold, oil and natural gas -- tend to beat the CPI, but not by nearly enough to compensate for their enormous risks (they are about twice as risky as the S&P 500). In fact, corporate bonds and equities actually appear to do a better job of keeping up with the CPI over time on a risk-adjusted basis, despite their low mathematical correlation.

A few specific investment recommendations, starting with the lowest hanging fruit:

  1. Increase your exposure to Treasury Inflation Protected Securities (TIPS) inside of your tax advantaged retirement accounts. Put a quarter or more of your retirement stash into TIPS. While TIPS are not tax efficient enough for taxable accounts, they provide a good inflation hedge for retirement accounts where taxes are either deferred or already paid.
  2. For your taxable accounts, buy $10,000 per year in Treasury I Bonds. Like TIPS, I Bonds provide solid protection against inflation. Unlike TIPS, you are not taxed on phantom income along the way. Because I Bonds are such a win-win, the government caps the amount that you can purchase each year to $5,000 in paper form and $5,000 in electronic form. So do both.
  3. Invest up to 15% of your portfolio in emerging market equities. To be sure, many of these markets have already experienced large gains recently. But they still offer a twofer of sorts: a hedge against U.S. currency depreciation as well as diversification into countries that still have strong growth prospects.
  4. Move some of your lower yield government bond portfolio toward Ginnie Mae centric mutual funds. Ginnie Mae's are the only mortgage-backed securities carrying the full faith and credit of the federal government. They usually provide a yield between one half a percent and one percent greater than comparable maturities.

In a future column, I will explain how exchange-traded options can be used to help manage risk.

To offer comments or to suggest topics for future columns, please use the comments feature on this page. All advice contained in this column is for general educational purposes only.