If you are thinking about investing money, then you need to know upfront what amount you’ll be looking at getting back, right? Many people who invest casually or just invest to take care of things such as retirement fail to take the all-important issue of inflation into account when doing the math. This can be detrimental to an investment portfolio, however, and understanding how inflation will affect your bottom line decades down the road is imperative to maximizing how hard your money will work for you.
Understanding Inflation-Protected Securities
Inflation-protected securities (IPS) are a great way to keep your money growth outpacing inflation, but to use them correctly, you fist need to grasp what they are. A standard-issue nominal bond has a principal, interest, and a guaranteed payout that you can calculate at maturity. The problem with investing in these over the long haul is you will have no idea what the rate of inflation will be on the date your bond matures, so you run a serious risk.
On the other hand, an inflation-protected security works in a similar manner as a bond, but the IPS accrues interest in two separate parts. First, the principal amount accrues along with inflation, and then the entire amount is paid when the IPS hits its maturity date. The actual coupon payment is made based on a real rate of return, so even though the IPS coupon is initially lower than a nominal bond, it’s paid out on both the principal and the interest that has accrued since it was originally purchased.
Should You Invest Heavily in IPS?
Quite a few different financial advisors think that investing in IPS qualifies as fixed income, but it’s not the case. In truth, these investment vehicles are their very own class of securities. You can’t really compare IPS investments to regular fixed income or equities because it just doesn’t make sense.
That’s precisely the reason that IPS make great additions to a portfolio for the sake of diversification. Of course, no one would want to invest in IPSs as a major chuck of their investment holdings because of the unpredictable nature of the possible returns, so investing in IPSs sparingly is the best way to diversify.
The reason that these are a fantastic way to round out your portfolio is that the rate of inflation is unpredictable, but when IPSs fluctuate in tandem with the rate of inflation, you won’t lose money as you would with a fixed investment of a similar nature. Fixed investments will earn the same rate of return, so the potential for real profits is not as secure as it is with their IPS counterparts. Moreover, since sovereign governments issue these bonds, there’s very little risk, so you can invest your money with confidence. Overall, it’s a good idea to add IPS coupons to your holdings to spread your money as far as possible to maximize your returns.