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Protecting Investments from Inflation

Today’s post comes courtesy of a question from The Personal Finance Clinic held by the moneygardener, Canadian Capitalist and Triaging My Way To Financial Success.

Vince writes,

My problem is as follows: I am an immigrant who has been in Canada for 6-7yrs and have no RRSP room to speak of, and can only count on a small CPP. All my savings and investments are in a non-registered account.

How do I protect myself against inflation? Do I buy short term bonds (XSB), real return bonds, or do I stay with common shares?

My allocation if I include property is about 60/40 FI/Equities.

Inflation is certainly a hot topic for many investors since every pundit in the media has an opinion of where inflation will appear and to what degree of severity with hyperinflation being a term that’s been thrown around far too loosely as governments attempt to stimulate economies.

Any conservative investor, regardless of risk or investment style, needs to concern themselves with inflation in all market conditions because inflation affects the real value of your investments. If your investment portfolio returned 4% after costs last year and the inflation rate was 2% your real return for the portfolio was only 2%. What an investor wants to do is achieve returns in their portfolio that outpace inflation over the long-term and provide them with equal or greater purchasing power in the future.

Investing for inflation is really not much different than wanting a raise each year that matches your increases in the cost of living. Essentially your portfolio should be giving you a raise each year in your income to offset the increasing prices of goods and services you use.

To answer Vince’s answer directly it’s not whether he should invest in only short-term bonds, real return bonds or common shares but how much of each to hold over the long-term.

Short-term bonds provide decent inflation protection at the expense of a much lower yield than a longer yielding bonds because you’re not taking on the same interest rate risk. Real return bonds maintain your investment from inflation and you only need to buy a weighting large enough for your desired allocation. Common shares, specifically ones that pay dividends, offer an investor a few advantages in terms of protecting against inflation. Companies that own/operate inflation sensitive assets such as real estate, commodities and infrastructure tend to fare better in valuation terms than other companies. Some dividends stocks pay a dividend and increase that dividend on a yearly basis above the annual rate of inflation then have already achieved your desired goal if the dividend continues to be paid regardless of the effect on share prices. Because dividends, for Canadians, are eligible for the Dividend Tax Credit in a non-registered portfolio the taxation of dividends is less than that of gains from interest (bonds & GIC’s) or from capital gains.

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