THE INTELLIGENT INVESTOR
JUNE 30, 2009
The Time to Tame Inflation Is Well Before It Strikes
By JASON ZWEIG
Insurance is often most worth having when it seems least necessary.
Right now, you might feel you don't need any insurance against a rise in the cost of living. Inflation, as measured by the Consumer Price Index, is running at negative-1.3% over the past 12 months; with oil and real estate down drastically, there are few signs of rising prices in daily life.
But the cost of living mightn't fall for much longer. So it is a good time to look at inflation insurance, in the form of U.S. Treasury Inflation-Protected Securities, or TIPS. The principal value of TIPS increases or decreases with the cost of living. Unlike normal bonds, TIPS don't get hammered when inflation rises.....
There is a historic tug of war under way between inflation and deflation, with the federal government borrowing $1.9 trillion in the past 12 months even as prices of many goods and services continue to fall.
"Inflation uncertainty is probably wider today than at any time before the financial crisis," says John Hollyer, co-manager of the $22 billion Vanguard Inflation-Protected Securities fund. "So having that protection in your portfolio is still valuable."
Even when prices are going up, many people fall prey to what is called "money illusion" -- the tendency to overlook the corrosive effects of a rising cost of living. You would probably rather have a 2% raise in a time of 4% inflation than a 2% pay cut in a time of zero inflation. The pay raise feels more positive and will make you happier than the pay cut -- even though both alternatives are economically identical, leaving you 2% poorer after inflation.
So if people are prone to this fallacy, why are TIPS funds hot? Through May, inflation-protected bond funds accounted for $10.4 billion, or 11%, of all the new money that flowed into stock and bond funds this year.
I worry that at least some buyers of these funds may be doing the right thing for the wrong reason. It seems implausible that, at the very moment when inflation seems to be least threatening, investors would get a sudden collective urge to protect against it. Instead of trying to protect against future inflation, many of these new investors may be chasing past performance. TIPS have gained 5.3% in 2009, versus a 4.4% loss on Treasurys overall, according to Vanguard. But, says Gang Hu, co-manager of Pimco Real Return fund, "a TIPS fund should be something you invest in for insurance, not for income."
I'm not sure Zweig is right about the returns chasing in the purchase of TIPs funds. There is definitely more concern about inflation among investors and more investors are learning about and thus using TIPs. And at least based on my experience there is relatively little knowledge among individual investors (and sad to say investment "professionals) of TIPs and their importance as a core portfolio holding. In many ways TIPs are the "perfect" fixed income investment as they eliminate the worst risk to a fixed income portfolio: locking into a fixed stream of interest income that doesn't keep up with inflation (negative real (after inflation) returns. Because of that imo they should be a permanent part of one's fixed income holdings.
.... the cost of living might rise faster than you expect; TIPS are priced as if inflation will run at an average rate over the next five years of no higher than 1%, and then will rise to 2.5% annually over the following five years. If those expectations are too low, TIPS will protect you.
TIPS offer baseline insurance against a rise in all the costs of living. However, TIPS aren't customizable. The official inflation basket consists of housing costs (43%), food (16%), transportation (15%), health care and recreation (6% each), apparel (4%) and education, communication and "other" (3% apiece). If the basket of goods and services that you pay for is significantly different from the CPI, then TIPS won't fully insure you.
So think about what makes up your personal inflation mix. If you are unlikely to qualify for financial aid, then the costs of educating your children could wildly exceed 3% of your expenses. So you might consider a prepaid college tuition program like the Independent "529 plan," assuming you are confident your child will be able to get into one of the participating schools.
The point about tutition is totally logical and what is called a "pure hedge"= worried about rising tuition costs lock in the cost of tuition.
But Zweig enters into specious reasoning with his proposed "hedge for future nursing home costs:
If you have aging parents, an assisted-living facility already costs an average of $3,000 a month; a semiprivate room in a nursing home runs more than $5,600 monthly. You can partially hedge against those rising costs with a stake in an exchange-traded fund like Vanguard Health Care or iShares Dow Jones U.S. Healthcare Providers Index.
The logic here totally escapes me
Why would shares of healthcare companies be a hedge against healthcare costs ? Listed below are the top ten holdings of the healthcare exchange traded fund (IYH)Healthcare costs rise largely because the costs of the inputs rise not because the healthcare companies are increasing their profit margins. Costs go up revenues of healthcare costs go up and profit margins remain unchanged. The growth in revenues on the top line of the healthcare companies doesn't mean increased profitiability therefore the healthcare stocks should go up no more than the general stock market. Their revenues may be (somewhat correlated) to inflation in healthcare costs but their profitability and future stock prices aren't. In fact Zweig is engaging in a bit of "money illusion" higher revenues mean nothing for a company if costs are going up as well.
More importantly, the major cost inputs for a nursing home are food, labor, real estate utilities and building maintenance. Listed below are the top ten holdings in the ishares healthcare etf. Ask any nursing home operator about the impact of price changes on these products is on the cost of a month in a nursing home. I suspect the answer will be zero, Virtually all of the costs of the products from these companies are covered by medicare or the patient individually, they are not included in that monthly nursing home bill
12.45% JOHNSON&JOHN SON
8.14% PFIZER INC
5.80% ABBOTT LABORATORIES
4.54% MERCK&CO. INC.
4.25% AMGEN INC
3.45% GILEAD SCIENCES INC
3.28% BRISTOL-MYERS SQUIBB CO
3.16% SCHERING-PLOUGH CORP
3.12% MEDTRONIC INC
*Holdings are subject to change.
Top Sectors as of 6/26/2009
65.44% Pharmaceuticals & Biotechnology
34.40% Health Care Equipment & Services