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A balloonist inflates the canopy of a hot air balloon for a test flight before the 2008 Chatsworth Country Fair in England.
A balloonist inflates the canopy of a hot air balloon for a test flight before the 2008 Chatsworth Country Fair in England.

Portfolio Strategy

Adjusting for inflation Add to ...

With governments turning to the printing press to solve their financial problems and developing nations continuing to expand their goods-hungry middle classes, investors will increasingly turn their attention toward the effects of inflation on their portfolios.

"The key to inflation risk is the basic premise that cash as an investment class is not wise because when one factors in inflation, cash loses its future value," says Sheryl Purdy, vice-president of Leede Financial Markets in Calgary.

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"Currently it is widely known that there are trillions of dollars being held as cash on the sidelines. This is a fact that seems to be forgotten, and clearly is a key component for investment planning for the second half of 2009 and into 2010."

Here are some things to consider when re-evaluating your portfolio in light of possible inflation in the next several years:



Commodities

There's a reason commodities tend to increase in value when inflation runs rampant - they are the very things that actually cause prices to increase in the first place.

"They cause inflation to move higher - it's the tail wagging the dog," said Patricia Mohr, commodity market specialist at Bank of Nova Scotia. "For example, when oil prices move up that is very much reflected in rising consumer prices. So it is actually a hedge against inflation to hold on to commodities."

Gold is a popular hedge. Peter Brieger, chairman and CEO of GlobeInvest Capital Management, says there are three main reasons to consider holding onto the precious metal.

"It protects against currency disasters, protects against inflation and is also insurance against other financial disasters," he says.

He suggests investors keep 10-15 per cent of precious metals in their portfolios - he splits his exposure between bullion and the iShares Canadian S&P/TSX global gold index fund .



Stocks

The companies that produce these commodities also tend to perform well in times of rising prices, says Ms. Purdy.

"Consider buying stocks of companies that own the basic materials that are used in manufacturing processes to make products. That is how one plans for inflationary environments, in my opinion," she says. "Canada has a wealth of choices available for investors, as a commodity-driven economy, I feel that we are in the right place at the right time."

She has recommended Imperial Metals Corp. to clients, as well as Canadian Natural Resources and Potash Corp. .

"Canada owns basic materials of scarce resources, thus in an inflationary environment, one would be wise in owning these types of companies, since production of products requires input of basic materials. Own companies that sell those basic materials in an inflationary environment."

The flipside is that the profits of companies that don't have control over their costs - the materials needed to manufacture their products - can be more vulnerable. They can raise prices to compensate, but risk losing consumers.

"The bottom line is companies that have control owver their pricing tend to do better," said Tom Collimore, director of investor education at CFA Institute.



Bonds

As far as asset classes go, bonds are vulnerable on two fronts. First, the cash stream generated by coupon payments loses value when inflation increases. Second, high inflation tends to mean high interest rates, which leads to lower bond prices.

That's why Jeff Black, a director and portfolio manager at Crestridge Asset Management, recommends investors look to real-return bonds. The bonds are only issued by the government, and guarantee a rate of return that is calculated after inflation is taken into account.

The bonds tend to come with lower coupon payments, which means your giving up some yield in order to achieve inflation-protect returns. Another downside, he says, is that the real-return bonds tend to have much longer maturities. He recommends complementing the holdings with an assortment of shorter-term corporate bonds that can be rolled over on a semi-regular basis.

"This way you have money maturing that you can reinvest at higher rates," he says.

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