Investing: Keeping Inflation at Bay

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Putting all your money in cash might be tempting, but inflation will hurt the buying power of that cash.

So how should investors prepare for the possibility of a prolonged period of higher inflation? A simple option is Treasury Inflation-Protected Securities, bonds that keep up with rising inflation since the yield is indexed to the consumer price index. Still, yields on TIPS are low, and financial adviser Kipley Lytel, of Montecito Capital Management, warns they have other disadvantages: They're not tax-friendly for some investors, and they rely on a government inflation adjustment that Lytel thinks is too low.

Looking for a Safe Haven

The "classic formula" for dealing with inflation, according to William Rutherford of Rutherford Investment Management: "Buy things, and go into debt." As inflation pushes up the prices of those "things"—such as real estate and commodities—it's much easier to pay off your original debt. This can be a risky strategy, however. Commodity prices are volatile and could be approaching "bubble" levels, Rutherford says. Meanwhile, real estate values are just about the only prices in the U.S. that are falling. Plus, the policymakers' likely reaction to inflation—higher interest rates—would make it hard to refinance high levels of debt.

Experts have a variety of advice for investors looking to protect their portfolios against inflation.

Perkins advises "looking for companies that have sustainable competitive advantages." Demand for their products should be so strong that higher raw-material costs can easily be passed on to consumers. She recommends companies with innovative products like Apple (AAPL) and robotic surgery technology outfit Intuitive Surgical (ISRG).

Rutherford has similar criteria, looking for companies with "pricing power" during inflationary times. Dow Chemical, with its recent big price increases, clearly has that power, he says. Other examples are makers of consumer necessities, like Procter & Gamble (PG), Kellogg (K), and General Mills (GIS). "At the end of the day, people do need to eat," he says.

Hats Off to Small-Caps

When inflation is higher, small-cap stocks benefit, Doug Roberts of Channel Capital Research says. Smaller companies do better during times of negative real interest rates, i.e. times—like now—when interest rates are lower than the inflation rate.

Lytel invests small portions of his clients' portfolios directly in one of the prime causes of inflation: commodities. He uses exchange-traded funds like the PowerShares DB Commodity Index Tracking Fund (DBC) or the Vanguard Energy Fund (VGENX). Rutherford, however, warns against ETFs focused too narrowly on volatile commodities like oil and gold. He would rather invest in commodities through big, diverse mining companies like BHP Billiton (BHP) or Rio Tinto (RTP).

Depending on where investors put their money, their portfolios might avoid damage from inflation. But consumers, forced to pay more for gas and food, have fewer options. Americans "in the bottom half of the economic spectrum" are hit the hardest, Merrill says. "It seems like these people can't catch a break." That's why, in case of inflation, Merrill advises staying away from retail stocks. "Retail in America is in a real uphill battle," he says.

Bringing On Uncertainty

Inflation is likely to punish anyone—and any company—that's not in good financial shape. "People and companies on the margins are going to have a tougher time," Rutherford says.

One of the biggest problems that inflation causes is uncertainty.

Commodity markets are priced for "hyperinflation," Roberts says, while bond markets predict little or no inflation. "One of them has to give," Roberts says. But which one? "We'll only know that in the rearview mirror," Perkins says.

Investors make money by correctly predicting the future. But inflation deals a wild card, making it much harder to anticipate the direction of the economy and the markets. The best investors can hope for is that it acts like an annoying—but mostly harmless—party crasher, who pesters the other guests but doesn't get out of control.

Steverman is a reporter for BusinessWeek's Investing channel.