It's easy to see why retirees in particular are concerned about inflation, because inflation is a big drag on anyone who's living on a fixed income. Whereas working people might receive salary hikes to compensate them for cost-of-living increases, most seniors are drawing upon their portfolios for at least a portion of their income, and rising prices erode the purchasing power of their withdrawals. Those rising costs are no small factor when compounded over many years, as I discussed in this article.
Inflation-Linked Bonds
I've written about inflation-linked bonds, particularly Treasuring Inflation-Protected Securities (TIPS) which are a common area of investment in the U.S., on several occasions, and to my mind they're the most cost-effective and efficient inflation protection you can buy.
Commodities
You might also consider a small slice of commodities in your portfolio--roughly 5%-6% at the high end, per guidance from Morningstar's Lifetime Allocation Indexes, powered by asset allocation specialist Ibbotson Associates. But if you're retired, be sure to pound-cost average into a commodity investment rather than adding it all in one go because mistiming a commodities investment can erode any long-term inflation-protection benefit you hoped to gain.
Emerging Markets
Before you layer on additional inflation protection, however, see if you already have any quasi-inflation hedges in your portfolio. For example, emerging markets tend to be heavy on basic-material producers, and they in turn are beneficiaries of higher demand and prices; check your portfolio's exposure to Latin America and developing Asian markets. (Morningstar's Instant X-Ray tool is a good way to investigate your portfolio's geographic exposure.)
Stocks
Stocks are another, indirect way to gird your portfolio against the threat of inflation. They have the potential for higher returns than bonds (though recent events are a harsh reminder of their potential for higher volatility too), and inflation will take a smaller bite, in percentage terms, out of your future purchasing power. Owning companies with a demonstrated history of dividend growth is another way to help offset the effects of inflation on your portfolio.
Also look at your portfolio's stake in energy stocks. They're not the same as owning commodities directly, but they have a fairly high correlation with energy prices, and energy is a major component of most commodities indices.
Christine Benz is director of personal finance with Morningstar; this article has been updated for the U.K. by Morningstar.co.uk editor Holly Cook.