How to Hedge Both Inflation and Deflation

This article is part of a package on concerns about inflation and deflation. To read the other article, see Inflation or Deflation: Which Economic Risk Is Greater?
On Monday, we discussed how you should incorporate the threat of inflation or deflation into your portfolio. Today, we'll talk about an investment vehicle that can help you hedge against both inflation and deflation -- TIPS.

Before we do, let's look at another way to address the issue of inflation: building a laddered portfolio. This involves buying a roughly equal amount of bonds that mature in each of the next 10 years, and then replacing the maturing bond with a new 10-year bond. You would have a portfolio with an average maturity of five years that would balance/diversify the risks of deflation (when reinvestment risk shows up) and inflation (when term risk rears its ugly head).

If rates have fallen when the first bond matures, the other nine bonds would still be earning above-market rates (though you would have to invest the proceeds at lower market rates). On the other hand, if rates rise, you'll be able to invest the proceeds at the now higher rates when the first bond matures.

Another benefit of a ladder is that after the initial period your portfolio will have the risk of a five-year bond but will have earned the average of the yields on the 10-year bond.

TIPS, however, give you a simple way to hedge the risks of inflation and deflation. In thinking about choosing between nominal bonds and TIPS, I have always found it helpful to think about the question in terms of Pascal's Wager. Blaise Pascal posited that even though the existence of God can't be determined through reason, a person should wager as though God exists -- because of the consequences of being wrong. As friend and fellow author William Bernstein points out: "If a supreme being doesn't exist, then all the devout has lost is the opportunity to fornicate, imbibe, and skip a lot of dull church services. But if God does exist, then the atheist roasts eternally in hell."

How does Pascal's Wager relate to the decision on whether to choose nominal or real return bonds? If you hold long-term nominal bonds, you win if deflation shows up. You lose, however, if inflation shows up, because your portfolio might not provide sufficient income to maintain your desired lifestyle.

With TIPS, you win either way. If inflation shows up, the return of your bonds keeps pace. With deflation, they do at least as well as in inflation because TIPS mature at par (though to be fair, nominal bonds would have performed better).

For example, a 10-year TIPS with a yield of 1 percent at par with inflation of 3 percent per year yields a nominal return of 4 percent a year and a real return of 1 percent. However, with deflation of 3 percent a year, the nominal return is still 1 percent a year, but the real return (the only return that matters) is 4 percent. You also have an added bonus in deflation, since for taxable accounts taxes are due on the nominal return.

Since none of us has a clear crystal ball, it's better to play an I win/I win game than an I win/I lose game. And if you still believe you can forecast the future with a high degree of accuracy, remember Pascal's Wager: The consequences of your decisions should dominate the probability of outcomes.

More on MoneyWatch:
How to Guard Against Inflation Through TIPS TIPS and Forecasted Inflation What to Consider When Buying TIPS Can Investing Be Too Simple? How Not to Create a Fortune