Gold May Not Protect You From Inflation

(MoneyWatch)  If you think gold is a sure fire defense against inflation, think again. Lots of people have been intrigued by gold's recent price increase -- at least until recently -- and it's being heavily marketed as a way to protect against inflation. But history does not bear this out. You should be skeptical of salesmen spinning stories about gold and its mystical wealth preservation powers.

Think about this, if gold were a guaranteed hedge against inflation, why did the price of gold fall from about $850 in January 1980 to about $250 in 1999? If you bought gold at $850 in 1980 during the last inflationary panic, you'd have waited about 28 years (until 2008) for it to regain its initial value. Not much of an inflation hedge.

Instead of thinking of gold as a direct inflation hedge, in modern markets it may serve more as a "financial panic" hedge. Investors were panicked about a financial collapse in the early 1980s and also today, and gold rose during each of those panics. But when the panic subsides, gold also tends to lose its luster.

There's nothing wrong with owning gold. But consider that if you own a diversified portfolio of stocks, such as the S&P 500, you have ownership in mining and other companies that derive their earnings from the commodity markets. If commodities are doing well, those companies are often doing well. So you have some skin in the commodities game just by owning diversified stocks.

If you would like an inflation hedge, there is an investment option that may provide a more direct correlation. It is called a Treasury Inflation Protected Security, commonly referred to as TIPS. These are U.S. government bonds that are designed to increase in value with increases in the consumer price index (and, conversely, decrease in the event of deflation).

If the US economy goes into a hyper-inflationary period, the principal value of the TIPS bonds would climb with inflation. This helps preserve your real, inflation-adjusted wealth.

Many 401(k) plans have TIPS as an option. It is a good idea to hold TIPS in tax-deferred accounts, because the increase in the value of the bond (based on the increased in the consumer price index) is taxable each year. This tax can be avoided if the bonds are held in a tax-deferred account, such as a 401(k)or IRA.

As with any investment decision, make sure you talk to your investment advisor about whether the option fits with your objectives.

Gold bullion image via Flickr user covilha, CC 2.0