Risks to your investments now: Inflation

Inflation and interest rates

While the U.S. inflation rate is far from the crushing double-digit levels of 35 years ago, higher energy and commodity costs are taking a toll on consumers and producers alike.

The question investors need to ask is how much of this sticker shock is due to speculation. When speculators grab hold of a market, prices can soar rapidly and sink just as quickly. Investors have to weigh that factor against supply-and-demand realities.

Coincident with inflation risk is interest-rate risk. Many market observers are convinced that rates have nowhere to go but up — and soon.

Rising rates reduce the value of existing bonds, especially longer-term issues, bringing pain to bond investors. The throngs who flocked to bond mutual funds over the past couple of years need only look at what happened to bond-fund share prices in 1994, when rates jumped. By the end of that year, the average taxable-bond fund had lost 3.3%, according to investment researcher Morningstar Inc. Already this year, shareholders of long-term government-bond funds and many municipal-bond funds are getting pinched.

Your best bet: Make sure your portfolio is broadly and efficiently diversified. Own U.S. and international stocks, commodities, inflation-protected bonds, real-estate investment trusts and cash, all of which have the ability to withstand inflationary bouts. Cash is king when interest rates rise, as money-market funds and bank certificates of deposit pay correspondingly more.

But don’t abandon traditional bonds. Diversification isn’t about maximizing return; it’s about minimizing risk. That means owning unpopular assets — because you could be wrong. High-quality U.S. and international corporate and government bonds of varying maturities, or bond funds that own these securities, provide you with diversification and lower the risk of a stock-heavy portfolio.

Many bond-market strategists nowadays advise controlling interest-rate risk by shortening a bond portfolio’s duration, or sensitivity to rate swings. Bonds that mature in five years or sooner, for example, don’t suffer as much as longer-term issues when rates climb, since once they mature their proceeds can be reinvested at prevailing higher yields. Bond funds don’t have maturity dates, but their investment objective is usually stated in the fund’s name, and the portfolio’s average duration is easily found online.

Finally, keep in mind that most assets nowadays are correlated, meaning they move in the same direction, though not to the same degree. In fact, the only global assets now that are truly uncorrelated with stocks, bonds, commodities and precious metals are Treasury bonds, according to Morningstar. If fears of sharply rising inflation and interest rates are unfounded, or when another geopolitical shock spurs investors to seek safety, Treasurys will be in good graces again.

http://www.marketwatch.com/story/the-4-biggest-risks-to-your-investments-now-2011-05-02?pagenumber=1