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Inflation has been rearing its ugly head lately. Partly because of the global economic boom, prices of commodities ranging from oil to corn have soared. As a result, energy and food prices are up sharply.
That's started to filter its way through the economy: In February, the U.S. government announced that wholesale prices were 7% higher in January versus the year before. Consumer prices didn't rise quite as quickly, but their 4.3% annual pace was higher than recent historical norms.
But even if all of the recent data are mere blips, consider that moderate inflation can take a heavy toll on your nest egg. Let's say inflation averages 3% over the next 30 years -- a rate not far from the Federal Reserve's long-term target. By the end of those three decades, $100,000 would be worth just $40,000 in today's dollars.
Should inflation trend higher, look out: If inflation clocked in at 6%, the purchasing power of $100,000 would fall to just $17,000. At 10%, $100,000 would be worth a meager $5,700 in today's dollars.
What can you do to guard your portfolio against the ravages of inflation? Here are some ways you can protect yourself.
Tilt your portfolio toward stocks
You're probably thinking that staking more in stocks is a bad idea if you're concerned about inflation. After all, the stock market's recent swoon got started when Federal Reserve Chairman Ben Bernanke went public with his inflation concerns.Investors fear Bernanke will go too far in raising interest rates and squelch economic growth in order to prove his inflation-fighting bona fides. Heightened inflation expectations also translate into higher interest rates because lenders want to make sure the value of their loans isn't eaten up by inflation. Higher rates also make it more expensive for businesses to borrow, which in turn slows economic growth. And with higher rates and a slower economy, stocks suffer, at least in the short term.
More from MSN Money and Morningstar
Looking at the long term, however, inflation may have a more neutral effect on stocks. "Stocks for the Long Run" author Jeremy Siegel points out that stock returns historically have been immune to inflation rates over long stretches of time. Although rising prices could crimp profits in the short term, Siegel argues that companies -- eventually -- can pass on those costs to consumers, making inflation a wash for stock market returns.
Even if the effects of inflation aren't as benign as Siegel presumes, stock investors are likely to fare better in an inflationary environment than bondholders are. With fixed coupons and principal payments, inflation takes an especially heavy toll on bonds (though not all bonds suffer in an inflationary environment). Stocks, though, have greater return potential than bonds, giving you a better shot at beating inflation.
It's true that favoring stocks over bonds does expose your portfolio to more volatility, but don't lose sight of other risks. Especially as life expectancies improve, there's the increased possibility that you'll outlive your assets. And inflation makes that challenge an uphill battle. Betting on stocks may seem like a risky, aggressive move, but doing so to make sure your portfolio lasts at least as long as you do is a defensive move.
Invest in inflation-protected securities
Most bonds pay interest on a principal amount that is fixed. When a bond reaches its maturity date, the principal, or face value, is repaid to creditors. But because of inflation, this amount won't be worth as much in real dollars as it was when you first invested it.One solution to this problem is to invest in Treasury inflation-protected securities, or TIPS. Issued by the U.S. government, TIPS provide virtual immunity from defaults, just like plain-vanilla Treasury bonds do. However, they are unlike traditional Treasurys in one important respect: If inflation rises, so will your principal. That's because TIPS' underlying principal readjusts every six months along with the Consumer Price Index. As a result, the purchasing power of your investment in TIPS will keep up with inflation.
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