Re-Building Your Portfolio (WSJ)

Even the experts can’t recognize whether rising or dropping prices lie in our future. That leaves investors in a quandary: how to construct a portfolio at the same time of great uncertainty. A wrong bet could be damaging. If your portfolio is built for deflation, for example, your assets will slump if the country experiences a bout of inflation instead. The answer is to get ready for the economic scenario you think is most probably, and build in some insurance if you’re wrong then.

Such a strategy always means some investments will suffer no matter how the economy transforms. The first can do best within an inflationary period but won’t be crushed if deflation instead rules the day. The second reason is for investors who fear deflation but want some safety against potential inflation — even if it’s down the road. And the third is aimed at investors who believe the economy shall muddle through without severe inflation or deflation. If you believe all the government spending in response to the financial crisis will eventually beget inflation, a collection is wanted by you that thrives in an interval of surging prices.

Commodities will be the primary play, because everything from oil and corn to copper and pork bellies should gain. Plus, commodities — particularly gold — hedge against the dollar, offering a 2-for-1 benefit if a weak dollar accompanies inflation, as some expect. Since goods contracts can be considered a hassle for individual investors, look at an account such as Pimco’s CommodityRealReturn Strategy Fund, which offers exposure to a broad swath of agricultural and industrial commodities. Though it appears counterintuitive, cash can do pretty well, too. The Federal Reserve would likely fight rising inflation by pushing up short-term interest rates, allowing traders with cash to capture the escalating rates through short-term certificates of deposit and money-market accounts.

Michele Gambera, chief economist at Ibbotson Associates, says his research implies that within the last five bouts of meaningful inflation, results on cash matched up the inflation rate, meaning it isn’t losing its purchasing power. Online banking institutions and local credit unions have a tendency to provide higher rates. Treasury inflation-protected securities, or TIPS, are an apparent investment since their principal adjusts upward along with inflation. Sharp inflation is generally a poor for stocks, because rising interest rates potentially pinch corporate profits and undermine financial growth. But a few shares will do fine likely. Focus on energy and metals stocks because higher prices for their commodities will boost earnings, says Mark Kiesel, a managing director at Pacific Investment Management Co., or Pimco.

Include as well U.S. Types of companies to consider: miners such as Freeport-McMoRan Copper & Gold and energy giant Exxon Mobil, or companies indirectly linked with commodity prices, such as driller Diamond Offshore Drilling, farm-equipment company Deere, and seed supplier Monsanto. Insurance Component: Long-term Treasury bonds and municipal bonds. Both will probably soar in value amid deflation because their long amount of fixed payments would be a stylish income source as prices for goods and services broadly fall, and as paychecks reduce.

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And Treasurys, specifically, would likely become a haven for international traders, further pushing up their price. Portfolio preparation is simpler for deflationists: Put a chunk of money into long-term Treasury bonds and many of the others into cash plus some municipal bonds. If broad-based deflation materializes, long-term Treasurys will probably surge.

The bonds’ fixed-income stream, meanwhile, would be well worth increasingly more relative to dropping consumer prices. Some investment-grade municipal bonds could serve a similar role, while also providing tax advantages for high-income earners. But beware: Deflation would likely mean some taxing authorities struggle to service bonds reliant on a particular income stream, like user fees. Instead, adhere to “investment-grade bonds linked with necessary services like drinking water and sewage, power or necessary Federal government offices like, say, a courthouse building,” says Marilyn Cohen, chief executive of bond-investment firm Envision Capital.

Round out your deflation profile with a big slug of cash. Though it will not generate a lot of a return in a low-rate, deflationary environment, profit the bank shall gain value as prices fall. Insurance Component: Commodities react most drastically to surprise inflation, so they must be part of your insurance.