Fundamentals of Market Investing by Adam J. McKee

I will tell you in a later section to never rely on investment tips, but as an acronym TIPS (Treasury Inflation Protected Securities) deserve some consideration.  In future chapters, I will try to convince you that inflation is the monster under the bed and that you should get a firm grasp on the concept so that you can combat its evil effects.  One weapon in our arsenal is to be really good at stock picking and make so much money that we don’t care about inflation.  I’ll also spend a lot of your time trying to convince you that this plan is a bad one.

That leaves us with other tools to combat the pernicious effects of inflation, and TIPS are in that arsenal.  TIPS really shine during periods of high inflation, and that is the reason that investors hate them with a white-hot intensity at present.  For the last decade, inflation has taken a break, and economists are still scratching their head about that fact.  However, as we shall see, the present is just a sliver of the timeline, and economic conditions will change.

Regular bonds have no protection against inflation, and if inflation spikes, you will lose money given the low-interest rates of today’s bonds.  The tradeoff is that bonds, even the super boring US Government ones, pay better than TIPS when inflation rates are low or falling.  The primary purpose of TIPS in a broader portfolio allocation strategy is to provide some insurance against sudden, unpredictable spikes in inflation.

You wouldn’t cancel your automobile insurance because you haven’t wrecked in a while, and trading in TIPS for regular government bonds is no different in logic.  As I will argue in the final chapter of this book, if you want a stable but growing portfolio that will help you pass the sleep test (most nights), you will need investments that offset losses in your riskier investments which much higher expected returns.

With TIPS, the government sets a basic rate of return that you will earn if inflation sits entirely still.  At present, that rate is 0.5%.  Add the current rate of inflation to that amount, and you get the yield of your TIPS.  In inflation-adjusted terms, your real return is always that level set by Uncle Sam.  If inflation explodes, so will the yield of TIPS, and the face value will go up as these investments start to look very attractive to traders.  Also, note that inflation is positively correlated with higher interest rates, so there is a double whammy when inflation rates spike, and you are holding unprotected bonds.  You have lower returns on your current bonds because of the effects of inflation, and the face value will dip because traders don’t value lower rate bonds when interest rates are rising.

I, therefore, suggest that you should own TIPS as a proportion of your total bond exposure.  If you are young and heavily invested in equities, then they will not help your portfolio enough to trouble with them.  As you grow older, you should have a much more extensive portfolio and have increased your bond exposure substantially.  You should have also become much more risk-averse.  Bonds are particularly susceptible to inflation risk (even if we haven’t seen it in a long time) and you should consider the value of TIPS as a hedge against the potential downside.  I’ll suggest an allocation for TIPS in the final chapter, and now you know why I advocate them.

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