Can investments protect you from inflation?

If you're worried that inflation might eat away at your savings and investments what can you do?.

In practice the only guaranteed way of doing so at present is to buy index-linked gilts at issue and hold them until redemption. But as this could mean holding them for 20+ years and new issues are sporadic this is unpractical for most of us. More on this in a moment.

National Savings Index-Linked Savings Certificates are a more practical way to beat inflation, tax-free, but are currently suspended from sale due to becoming too popular (they probably became an overly expensive form of borrowing for the Government).

So if there's no cast iron method of protecting against inflation, is there anything you can do to at least stacks the odds in your favour? Let's take a look.

Cash

With the sale of National Savings Index-Linked Certificates being withdrawn in July 2010 there's currently no guaranteed way of beating inflation with your savings. The best you can do is to find a market leading savings interest rate, tax-free via an ISA if viable, and hope for the best.

What kind of rates are currently on offer? At the time of writing you can earn around 3% a year before tax on easy access accounts and up to 4.75% on a five year fixed rate account. However, the rates paid by variable rate accounts tend to be very fickle, often plunging over time, so it's a good idea to regularly check the rate paid and take your business elsewhere if necessary.

Gilts / Corporate Bonds

Income from conventional gilts and corporate bonds might beat inflation longer term, but there's no guarantee. And inflation means your initial investment will be worth less in real terms when you get it back at redemption (maturity), so high expected inflation usually depresses gilt/bond prices. I wouldn't recommend these investments if you're worried we're entering a prolonged period of high inflation.

Index-linked gilts guarantee that both your initial investment and interest will increase by inflation, measured by the Retail Price Index (RPI). However, as mentioned above, this only works if you buy when they're initially issued and hold until redemption, which could be a very long time.

Why? Because after issue the gilts are traded on the open market and their price will reflect what the markets expects average inflation to be until redemption. If you buy index-linked gilts at a time when inflation is expected to be high and these expectations subsequently subside, their price might fall. For more information and examples read my answer to this question.

Commercial Property

Rental income from commercial properties (e.g. offices, shops and factories) tends to keep pace with inflation longer term as landlords usually build in periodic rent reviews for this reason.

But beware, during periods of economic turmoil it might be harder to negotiate rent rises, tenants are more likely to go bust and property values may fall, so there's some risk. Commercial property funds have lost around 12% on average (including income) over the last 5 years - losing money is hardly a good hedge against inflation. Nevertheless, commercial property should be a sensible long term hedge against inflation if you're confident we won't fall back into recession.

Residential Property

Residential property rental income tends to influenced by interest rates and the availability of mortgages. The harder it is to buy a property the greater the demand for rentals, which should push up rents. There's little evidence to suggest to rents consistently keep pace with inflation long term.

The larger slice of past returns have come from rising prices, not rent. But given the current outlook for house prices I wouldn't expect rises for at least a couple of years.

Stockmarkets

Dividends have historically kept pace with inflation pretty well. For example, between 2006 and 2010 Imperial Tobacco's full year dividend rose from 62p to 84.3p, a 36% rise while inflation over the period was about 18%. Of course, not all companies have fared so well during the credit crunch - Barclays' dividend fell by more than 85% over the same period. But chosen carefully, shares can be a good long term source of inflation-beating income.

The trouble is share prices are far less predictable. A decent income is little consolation if market falls lose you a fortune. They key with stockmarket investing is the willingness to stay put for 10 or more years, reducing the impact of shorter term volatility.

Gold

Gold is often perceived as a good hedge against inflation and has a good record of doing so longer term. However, the gold price can also be very volatile shorter term and demand from nervous investors has pushed prices to record levels in recent times.

Structured Products

Some financial providers build investments, often called 'structured products', that aim to match or beat inflation. Current examples include the RBS Exchange Traded Bonds (read our review here) and the Jubilee Financial Real Growth Plan (which offers the higher of stockmarket returns and inflation over six years).

These products can sometimes be worthwhile provided you understand exactly what you're buying (they can be complex). But bear in mind that these are 'artificial' investments, which rely on underlying investment banks agreeing to pay the returns on offer. If the bank(s) goes bust you could lose money.

Conclusion

A combination of high dividend shares, commercial property and index-linked gilts are likely to provide decent long term protection from inflation. But if you're worried about the threat from inflation over just a year or two then there's little you can realistically do - just ensure you get the very best interest rate on your savings that you can.

Read this article at http://www.candidmoney.com/articles/article190.aspx