Size Up Your Inflation Risk, Then Gird for the Possible
Kathy Kristof

Do you need to worry about inflation?

Prices for goods and services have been relatively tame for the last three decades, but billionaire investor Warren Buffett recently put words to the fear of many market professionals. Inflation may not be around the corner. But, he said in a recent opinion piece, unless something is done to curb government deficits, inflation could hit with a vengeance when the economy starts to gain steam.

Those who lived through the 1970s know that inflation can be crippling, vastly boosting the cost of living without improving the quality of life. But you can reduce the potential effect on your own finances by assessing your personal inflation risk and taking steps to mitigate it.

"You don't have to see the whites of inflation's eyes before you do something about it," said Gary Schlossberg, senior economist with Wells Capital Management in San Francisco, Calif.

What can you do? Your first step is to assess your inflation risk, said Judi Martindale, a certified financial planner in San Luis Obispo, Calif.

Not everyone is hit by inflation in the same way or with the same magnitude. In fact, she said, retirees may welcome inflationary times because the Social Security portion of their monthly income is inflation-adjusted and many of their costs are fixed.

Inflation is likely to boost market interest rates, which could land retirees more generous investment returns on their certificates of deposit and other savings accounts.

On the other hand, young renters who owe significant sums on variable-rate credit cards could be savaged.

The only way to assess the effect on you is to pull out a copy of your annual budget (or create one) and start going through which items would and wouldn't be subject to rising costs.

For instance, the average family spends about one-third of its budget on housing, according to the Labor Department, which tracks household expenditures. But that expense is broken into several pieces. Your rent or mortgage would be the biggest piece, followed by property taxes (for owners), household furnishings, maintenance, utilities and housekeeping.

If you're a homeowner with a fixed-rate mortgage, the biggest piece of your housing expense is exempt from inflation. But those smaller pieces are not. And, of course, if you've financed with an adjustable mortgage or a home equity line of credit, the cost of your home loan probably would rise steeply with inflation.

As for renters, even in rent-controlled areas, rent hikes are often indexed to inflation. So if inflation rises sharply, so can the cost of keeping a roof overhead.

The same holds true with the average person's second-largest cost: transportation. If you have a fixed payment for your auto loan, you've stopped inflation on that part of your budget. If you've financed your car purchase with a home equity line of credit, your rate is probably variable and could rise. So could the costs for gasoline and repairs.

Food, clothing and healthcare are affected by inflation. But you can control the amount you spend on discretionary items such as entertainment, savings and charity.

Add up the amounts that you've tagged as being either fixed or discretionary and compare those with the total to determine how inflation-vulnerable you are.

If the bulk of your costs are exempt from inflation, there's no reason to do more. But if you find that more than half of your budget could be affected by rising costs, you might want to make some changes.

The most obvious would be to refinance variable-rate debt into fixed-rate -- or simply pay off those variable-rate loans.

"If you batten down the hatches by fixing your major expenses -- your mortgage, auto loans and other debts, you can survive an inflationary environment," said Marilyn Cohen, president of Envision Capital Management in Beverly Hills.

Because inflation is a risk, not yet a reality, there's no need to be rash, she added. Just look for opportunities to refinance when financing rates are cheap. In the meantime, you might want to pare back spending to pay down debt when refinancing is impractical.

Your investment portfolio should also have an inflation-fighting component, Cohen said.

Popular inflation-fighting investments are gold and commodities, real estate and Treasury Inflation-Protected Securities, also known as TIPS.

It's easy to explain how TIPS fight inflation. The interest rate on these securities floats above the consumer price index, ensuring investors that their value will keep pace with inflation, but it never exceeds inflation by much. Cohen's not a fan, because she thinks you can do better.

The other investments don't move in lock step with inflation. But the demand for gold and commodities rises when people are concerned about maintaining their buying power, she noted.

Cohen thinks exchange-traded funds in gold and commodities have more "bounce for the ounce" than TIPS. They're also far more volatile, however, so investors need to be quick on their feet, getting out when it appears that inflation is under control.

The other thing investors should do over the coming year is consider selling their long-term bonds, Cohen said.

"Inflation is the bane of the bond market's existence," she said. When interest rates rise, the value of old (relatively lower-rate) bonds falls, she said. The longer the maturity on the bond, the steeper the drop.

Again, because there's no rush, investors can sell "in a measured way," allowing some bonds simply to mature and selling others when market conditions are good, she said. That would free up cash to reinvest when inflation does hit and interest rates start to rise, providing investors with more generous yields.

"It's not time to press the panic button, but that's why you do it now," she said. "Anyone managing their own money has to be aware of the fact that what's fashionable today may not be viable tomorrow. Timing does matter."