As we discuss below, there are only a handful of asset classes that closely track inflation. Further, several strategies that are commonly thought of as being effective ways to protect against the risk of inflation have actually been ineffective, in particular over relatively short time periods.

 

Historically, the two most effective ways to protect against the risk of unexpected high inflation have been allocating a portion of your portfolio to Treasury inflation-protected securities (TIPS) and commodities. TIPS are bonds that are issued by the U.S. Treasury that have principal and interest payments that are directly linked to the U.S. Consumer Price Index (CPI). All else equal, this means that when inflation goes up, the value of the bond and the level of future interest payments will go up as well. From a held-to-maturity point of view, TIPS are virtually guaranteed to provide you with a return of realized inflation over the period that you held the TIPS plus an amount above the level of inflation (or minus an amount, as has unfortunately been the case for short-term TIPS over the past couple of years).

 

The two most well-known commodities indexes are the Dow Jones-UBS Commodity Index and the S&P GSCI Commodity Index. The Dow Jones-UBS Commodity Index had a correlation of about 0.50 with inflation over quarterly periods covering early 1991 through late 2010, and the S&P GSCI Commodity Index had a correlation of about 0.60 over the same time. What these numbers mean is that when inflation has been above its average, the returns of these diversified commodities indexes have tended to be above their averages as well. And while these numbers may not sound high, they are relative to all other broadly diversified asset classes that we have analyzed. For example, over this same period, the correlation of the S&P 500 Index with inflation was only 0.10.