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Guard your portfolio against inflation

Inflation is like a rodent nibbling away at your future purchasing power. Sometimes the critter takes big bites, sometimes little bitty ones.

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But whether inflation is raging as it did in the 1980s or fairly calm as it is now, it's almost always with us, nibbling away. That's why a portion of your portfolio should be reserved for investments that help compensate for inflation.

The average annual rate of inflation for 2005 was 3.4 percent, and 2006 is expected to come in around 4 percent.

Suppose you set aside $10,000 in 1996 for your 8-year-old child's college education. Now it's 2006 and, thanks to inflation, what you could have bought 10 years ago for $10,000 will cost you nearly $13,000 this year.

Another way to look at this devastation is with the rule of 72, which is often used to see how long it will take to double your money at a given interest rate. If you're earning 5 percent interest on a $10,000 certificate of deposit, divide 72 by 5 to see that it will take 14.4 years to double your money at that interest rate.

Conversely, the rule of 72 can be used to see how long it will take a particular rate of inflation to cut your purchasing power in half. At 3.5 percent, inflation will halve the purchasing power of your money in about 20 years. That can be a little unsettling if you're pouring part of your paycheck into a retirement plan that you'll be leaning on 20 or 30 years from now.

The challenge is to find investments that will earn a rate of return that will help your portfolio offset inflation without going outside your comfort zone in terms of risk tolerance.

"A lot of people, when they're heading toward retirement, start investing in ultrasafe investments and end up losing money because they can't keep pace with inflation," says Fred Forbes, Certified Financial Planner and principal of Financial Factors in Palmetto, Fla.

Forbes likes real estate, especially commercial real estate, as a bulwark against inflation. He suggests that investors look into real estate investment trusts, or REITs, exchange-traded funds, and mutual funds that specialize in real estate securities.

One of the newer ways to tackle inflation is inflation-linked CDs, or IFCDs. They've been around for about two years and, according to the folks who developed them, are tremendously popular. IFCDs have a floating rate coupon that changes monthly based on the government's inflation measuring stick, the Consumer Price Index, as compared to the same period a year ago.

"Keep in mind that it's the year-over-year change in the inflation rate versus the rate that's quoted monthly, so it translates into a bigger coupon," says Patrick Kelly, managing director at LaSalle Broker-Dealer Services in Boca Raton, Fla.

"We have a two-year inflation-linked CD issued by LaSalle Bank and LaSalle Bank Midwest. The base coupon is 1.85 percent plus the year-over-year inflation rate. That brings the coupon to 6 percent, because the year-over-year Consumer Price Index rate is 4.15 percent. The year-over-year CPI rate adjusts monthly so every month a new rate is determined and you add that to the base rate to get the coupon. We also have a five-year with a base rate of 2 percent, so the coupon is 6.15 percent."

Kelly says one reason for the IFCD's popularity is that consumers like the inflation link being tied to the monthly coupon payment, versus the government's Treasury Inflation-Protected Securities, or TIPS, which adds the inflation premium to the principal, something the consumer doesn't receive until maturity.

IFCDs are FDIC-insured and can be purchased through brokers and financial advisers.

Inflation-protected InterNotes are inflation-protected corporate bonds. The interest payment is adjusted for inflation and has two components, the fixed amount, which is stated when you buy the bond, and an inflation-adjusted amount based on the CPI that's calculated monthly. The principal remains the same and is returned at maturity. Many brokerages offer InterNotes, or you can visit the Web site of Incapital, the company that created InterNotes.

Another government option is the I bond. The savings bond's interest rate also has two components, a fixed rate that stays with the bond for 30 years and an inflation-adjusted rate that changes every May and November. Interest accrues and is paid at redemption.

You must hold I bonds for one year before cashing and, if you cash out in less than five years, you'll lose the three most recent months' interest. For more on I bonds, read "Series I-bonds: Your protection against inflation." Federal government securities are exempt from state and local taxes.

Next: "You have to have something that fights inflation."
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