Are TIPS the ultimate inflation hedge?

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nobsinvestor
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Are TIPS the ultimate inflation hedge?

Post by nobsinvestor »

Wanted to post a new thread inspired by a similar one running right now.

So it appears that many investors are concerned with "inflation hedge" assets such as gold, metals, a metals mutual fund, or real estate/REITs.

My question is- why bother with any other asset other than say Vanguard's TIPS mutual fund if you are solely concerned with an inflation hedge?

Are TIPS not the ultimate, government-backed inflation hedge?
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Re: Are TIPS the ultimate inflation hedge?

Post by dh »

Good question! My concern about a TIPS mutual fund is the potential for rising interest rates should inflation occur. I think of my individual I-Bonds as my "ultimate inflation hedge." I do not own Gold or other precious metals. Thanks for asking the question as I look forward to others comments.
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Re: Are TIPS the ultimate inflation hedge?

Post by nisiprius »

Yes, they are. With caveats and footnotes. Like index funds, they are simple, direct, head-on solution to a problem.

And they track the CPI directly, unlike a host of other investments that sorta-kinda-theoretically-tend-to-except-when-they-don't.

Someone made a joke that TIPS are "The Investment Professionals Shun." There is a distinct anti-TIPS bias in the financial press, I'm not quite sure why. People (e.g. Warren Buffett) will fulminate about the terrible danger of "bonds" in times of inflation and seem to act as if TIPS don't exist.

The caveats are that

1) bond funds are bond funds and have the issues bond funds have--there's no fixed maturity date so you are never immune from market fluctuations.

2) TIPS merely keep up with inflation. People say they want to keep up with inflation. When you point out that TIPS do that, they change ground and say, well, they don't just want to keep up with inflation, they want to do better than inflation even if it involves taking on more risk.

3) All investments are subject to taxation, and, regrettably, taxation is assessed on the number of dollars in increase. Therefore, even if you have only kept up with inflation and made no real gain, you get taxed on the dollar increase--and do not keep up with inflation after taxes. This is true of any investment that only just barely keeps up with inflation--it doesn't keep up with inflation after taxes. For example, stocks from 1966 to 1982. However, people always bring it up in connection with TIPS. Anyway, in a taxable account, after taxes,TIPS will not keep up with inflation if it is rapid enough.

4) TIPS are not as heavily traded as other Treasuries and appear to be subject to more market fluctuation, including an ugly 10% drop in 2008-2009 that might have been due to liquidity problems.
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Re: Are TIPS the ultimate inflation hedge?

Post by Texas Radio »

I don't think so. 1) the yield is soooo low; and 2) the CPI is a manipulated almost nonsensical index

We hold physical precious metals which serve as an inflation hedge, have a strong degree of negative correlation to the S&P and are insurance against a currency collapse. Granted there is no yield for these metals but they are pretty! :D
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Re: Are TIPS the ultimate inflation hedge?

Post by saltycaper »

TIPS win hands down for me. Gold is the worst. (Global economic catastrophe hedge, maybe, but not inflation specifically.) Commodities, REITs, and stocks in general have greater risks and price swings. Short-term treasuries cannot be relied upon for consistent real returns.
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Re: Are TIPS the ultimate inflation hedge?

Post by furwut »

I don't think so. 1) the yield is soooo low; and 2) the CPI is a manipulated almost nonsensical index
The current yield is low because inflation is low.

There is NO evidence that the index is manipulated. Besides the official government figures closely matches Billion Prices Project numbers. Maybe you believe that is manipulated as well? The conspiracy grows!

EDIT
FYI - here is a comparison of CPI versus the BillionPrices Project (BPP)
http://bpp.mit.edu/usa/
Last edited by furwut on Tue Feb 03, 2015 9:04 pm, edited 1 time in total.
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Re: Are TIPS the ultimate inflation hedge?

Post by rj49 »

One of the problems with TIPS is investor behavior, namely the urge to flee when you're not getting rewarded through inflation adjustments--I sold a lot of the old 3% ibonds when inflation was so low and the market was booming. Then there's the complexity, especially in taxable accounts, and figuring out ibond current yields is also perplexing. Finally, you can get huge drops, as in 2007-2008, and a drop like that make funds seem less than safe.

For those who are eligible, the TSP G fund has kept ahead of inflation over the years, from charts I remember seeing, and there's no NAV fluctuation and no interest rate risk (although it's also difficult to stick with when yields are so low, as at present).

Then owning one's own residence is probably the biggest inflation hedge one can make, especially with rising rents in many places (although those who compulsively spend on housing improvements/upgrades/new appliances/landscaping) would probably negate a lot of the inflation hedge, although it can also play a much larger role in reducing personal inflation by downsizing if possible.

Finally, if you read books like "Your Money Or Your Life", some claim that reducing one's spending through hedonic adjustments and a simpler lifestyle, along with living healthy to lower lifetime medical costs, is the best way to manage personal inflation. I'd think not supporting adult children is also an effective way to help prepare for future inflation, especially since every dollar that goes to Johnny's iPhone bill isn't one that can be invested for one's own retirement.
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Re: Are TIPS the ultimate inflation hedge?

Post by nisiprius »

rj49 wrote:...Then owning one's own residence is probably the biggest inflation hedge one can make...
I don't think so. It is a speculative investment.

What I think is the longest financial data series ever compiled, real estate prices in the Herengracht district of Amsterdam, suffered a crash from 300 to 60 around 1790 and stayed down for a century.

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Re: Are TIPS the ultimate inflation hedge?

Post by bhsince87 »

Tips are good. A fixed rate loan, especially a 30 year fixed rate mortgage can be even better.
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Re: Are TIPS the ultimate inflation hedge?

Post by Johno »

TIPS are the most direct inflation hedge, except for any other product which is or might be offered by another issuer which is also directly tied to CPI. For example, CPI adjusted annuities: not the same credit risk as TIPS, not necessarily suitable for all investment purposes (though perhaps more suitable for some purposes than TIPS), but similarly direct.

I don't see low TIPS real yields as a drawback per se; that's the market now, nominal bonds of high quality have very low yields too, and I think one kids oneself to suppose the relatively low expected returns aren't also baked into equity now. But some basic limitations of TIPS IMO are:
-they make you dependent on the suitability, accuracy and honesty of CPI as a measure of inflation. Other inflation hedges will always track govt inflation figures more loosely than TIPS, but will track the cost of living more accurately in a case where govt inflation figures are *actually* cooked. That's not true now in the US (I don't believe statements like 'CPI is a manipulated almost meaningless index' can be backed up with actual facts as of now). But it is true for example in Argentina. One can't rule out the risk it might become so in the US

-more immediately, the general correlation between real rates and inflation expectations is such that TIPS probably get cheaper (higher real yield) when inflation expectations are higher. IOW if TIPS paid you a real return *upfront* and then adjusted your principal for inflation over time, they'd be closer to 'the ultimate inflation hedge'. But as it is they have duration risk on the present value of the real coupon, and as long as markets generally expect the Fed to respond to higher inflationary pressure with higher real rates, I believe that will be a generally unfavorable correlation for TIPS investors.

-as mentioned, in 2008-9 they cheapened in time of crisis. Whether that was the rapidly changing wisdom of the efficient market or an inefficiency, it's uncomfortable to have a 'safe' asset which goes down in value in a crisis.

-back to unlikely but non-zero longer term risks, the US govt is not a 'riskless' issuer. The US has serious long term fiscal problems it might well solve, but there is no gtee that will be the case. Concentrating all risk in long term US govt debt is unwise in my personal opinion, though I see no problem with moderate maturity US govt risk, or long term US govt risk in limited doses. It's low risk, but practically not just theoretically different from no risk, IMO.

I don't see an obviously better inflation hedge than TIPS though. I think real estate has its place as well. Gold I would personally relegate to a lower tier, smaller % of portfolio, for 'unknown unknowns'. I wouldn't put it in the same category as TIPS or real estate. Stocks aren't a good hedge historically against serious unexpected inflation though not as bad as nominal bonds.
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Re: Are TIPS the ultimate inflation hedge?

Post by john94549 »

If you do the math, and adjust for taxes (federal and state), you can probably do better with a five-year ladder of five-year CDs.
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Re: Are TIPS the ultimate inflation hedge?

Post by tarnation »

rj49 wrote:For those who are eligible, the TSP G fund has kept ahead of inflation over the years, from charts I remember seeing, and there's no NAV fluctuation and no interest rate risk (although it's also difficult to stick with when yields are so low, as at present).
Everyone (almost) is eligible now with the myRA. (worst named program ever). I agree a good choice against inflation second to long term (>10 yrs.) individual tips held to maturity. It is not perfect in that some years it under-paced inflation, but data shows return of 3.340% over inflation from 1979-2013 and no four year periods where it was below. Most recent history has been the hardest.
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Re: Are TIPS the ultimate inflation hedge?

Post by saltycaper »

nisiprius wrote:4) TIPS are not as heavily traded as other Treasuries and appear to be subject to more market fluctuation, including an ugly 10% drop in 2008-2009 that might have been due to liquidity problems.
This was a very interesting drop, which is seen in the chart for VIPSX:

Image

I have seen the possibility of a liquidity issue mentioned before, but is this the only reasonable explanation? It doesn't seem so.

The CPI fell from 219.964 in July 2008 to 210.228 in December 2008, a drop of 4.43%. Mathematically, one would expect TIPS to fall too due to the falling inflation factor and therefore the reduced inflation-adjusted principal.

July: 219.964
August: 219.086
September: 218.783
October: 216.573
November: 212.425
December: 210.228

The greatest drop in October to November corresponds with the steepest decline in VIPSX. Further, expectations of worsening deflation likely sent people fleeing from TIPS, further depressing prices.

Not to say this might not have caused a liquidity problem. I don't know. But it's an important behavior of TIPS for people to note. There might have been nothing particularly special about 2008 as relates to TIPS other than deflation.

Interestingly, over the same time period, the falling fed funds rate seemed to do nothing to help TIPS. Expectation of deflation trumped moves motivated by interest rates while nominal long-term bonds soared.

Fed funds rate:
2008-07-01 - 2.01
2008-08-01 - 2.00
2008-09-01 - 1.81
2008-10-01 - 0.97
2008-11-01 - 0.39
2008-12-01 - 0.16
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Re: Are TIPS the ultimate inflation hedge?

Post by nedsaid »

nobsinvestor wrote:Wanted to post a new thread inspired by a similar one running right now.

So it appears that many investors are concerned with "inflation hedge" assets such as gold, metals, a metals mutual fund, or real estate/REITs.

My question is- why bother with any other asset other than say Vanguard's TIPS mutual fund if you are solely concerned with an inflation hedge?

Are TIPS not the ultimate, government-backed inflation hedge?
If you are fighting inflation, you want more than one tool in the toolbox as markets are unpredictable and asset classes do not obey our expectations. If inflation rears its head again, TIPS may not act as expected. I own them and endorse them as an inflation hedge. But stocks in general are a good inflation hedge though you might wait a while (several years) before getting your inflation adjustment. REITs have been a great inflation hedge as the landlords can raise rents and property values also tend to grow with inflation. Natural resource stocks are heavily influenced by commodity prices and would most likely perform well with inflation.

Physical gold, commodity futures, and precious metal funds may act more like portfolio insurance. Over time, I would expect that you would get very little return above inflation from these investments. They tend to have little correlation with the broad stock market and if you carefully rebalance, you might get a rebalancing bonus if you keep them as a fixed percentage of your portfolio.

So to fight inflation, put something more than TIPS in the toolbox. Have other inflation fighters in there as well.
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Re: Are TIPS the ultimate inflation hedge?

Post by nobsinvestor »

Thanks for the replies so far.

Maybe another interesting debate is- how bad is unexpected inflation anyways, over the long run (10+ years)?

In US history, we never had a multi-decade period of soaring inflation. It seems like the central bank both here in the US and abroad will do everything it in its power to reign in inflation.

Maybe we're positioning our portfolio for something that is not a long-period lasting threat? Perhaps all that money put in "Real return" assets would be better put into more stocks and nominal bonds?
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Re: Are TIPS the ultimate inflation hedge?

Post by msi »

nobsinvestor wrote:Thanks for the replies so far.

Maybe another interesting debate is- how bad is unexpected inflation anyways, over the long run (10+ years)?

In US history, we never had a multi-decade period of soaring inflation. It seems like the central bank both here in the US and abroad will do everything it in its power to reign in inflation.

Maybe we're positioning our portfolio for something that is not a long-period lasting threat? Perhaps all that money put in "Real return" assets would be better put into more stocks and nominal bonds?
Another way of looking at it: It has been a long time since soaring inflation. Maybe investors have become too complacent, and all the cash central banks are pumping into the financial system will end up being more inflationary than they think. It wouldn't necessarily take a multiple decade period of soaring inflation to erode a substantial amount of your portfolio's purchasing power, either.
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Re: Are TIPS the ultimate inflation hedge?

Post by scone »

No matter how hard I try, I just can't seem to really, deeply, truly understand TIPS. For instance, people say TIPs are designed to counter unexpected inflation, but they use them to product against garden variety expected normal inflation. But TIPS typically don't pay as well as nominal Treasuries under "normal" circumstances, so how does that work?

The Lehman liquidity event is a mystery to me. Was that caused simply by dumping TIPS, or was it the "natural" behavior of TIPS in a deflationary crisis? Did TIPS correctly "diagnose" what was going on at the time, and will they behave like this again if we have a similar crisis? If that's the case, it seems to me you would want long nominal Treasuries to balance TIPS, so you are protected both ways-- inflation and deflation.

But at the same time, it's shocking to see Treasuries-- and TIPS are Treasuries-- fall badly in a crisis. It hurts to give up space in the portfolio to a bond that might make your drawdowns worse in a market panic.

Finally, it seems to me the purpose of TIPS, from the issuer's POV, is to measure inflation expectations. For that, they don't need a lot of TIPS, it's simply a dipstick into the market. So TIPS may never become a huge, liquid market like nominal Treasuries, and that bugs me. If TIPS became hard to sell for whatever reason, what then? Especially since even nominal Treasures are not quite as liquid as they might be, there's a bit of a shortage at the moment, and that's a concern too.

It seems to me TIPS have "unknown unknowns" and part of that is their short history. If only they had been around in the 70s, and not just synthetic models of them, so we could really see how they perform in an inflationary crisis! But we don't have that. In fact sometimes I wonder whether we will ever see a replay of the 70s again, since it was a combination of circumstances that aren't likely to "rhyme" quite the same in the future.

So, I just don't know. I ought to love TIPS, but I always come away scratching my head, not knowing what to think. :confused
Last edited by scone on Wed Feb 04, 2015 5:49 am, edited 1 time in total.
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Re: Are TIPS the ultimate inflation hedge?

Post by richard »

There are inflation derivatives that are pure inflation hedges. They do not seem to be available to retail investors and are not very liquid compared to TIPS.
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Re: Are TIPS the ultimate inflation hedge?

Post by richard »

Vanguard TIPS v intermediate treasuries
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Re: Are TIPS the ultimate inflation hedge?

Post by Grt2bOutdoors »

tarnation wrote:
rj49 wrote:For those who are eligible, the TSP G fund has kept ahead of inflation over the years, from charts I remember seeing, and there's no NAV fluctuation and no interest rate risk (although it's also difficult to stick with when yields are so low, as at present).
Everyone (almost) is eligible now with the myRA. (worst named program ever). I agree a good choice against inflation second to long term (>10 yrs.) individual tips held to maturity. It is not perfect in that some years it under-paced inflation, but data shows return of 3.340% over inflation from 1979-2013 and no four year periods where it was below. Most recent history has been the hardest.
Subject to income limitations and the low maximum value of $15K doesn't provide much of an inflation hedge if your portfolio is larger than $100K. If you don't feel comfortable holding TIPs as part of an LMP ladder, then hold I bonds, again though, the low annual maximum purchase permitted kind of prevents one from being able to maximize their portfolio holdings with these savings bonds unless purchased over time. Otherwise, the only real inflation linked bond that is US government issued is the TIP. If you hold to maturity, you'll be okay.
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Re: Are TIPS the ultimate inflation hedge?

Post by Johno »

scone wrote:1. For instance, people say TIPs are designed to counter unexpected inflation, but they use them to product against garden variety expected normal inflation. But TIPS typically don't pay as well as nominal Treasuries under "normal" circumstances, so how does that work?

2. The Lehman liquidity event is a mystery to me. Was that caused simply by dumping TIPS, or was it the "natural" behavior of TIPS in a deflationary crisis?

3. Finally, it seems to me the purpose of TIPS, from the issuer's POV, is to measure inflation expectations. For that, they don't need a lot of TIPS, it's simply a dipstick into the market. So TIPS may never become a huge, liquid market like nominal Treasuries, and that bugs me.

4. It seems to me TIPS have "unknown unknowns" and part of that is their short history. If only they had been around in the 70s, and not just synthetic models of them, so we could really see how they perform in an inflationary crisis!
1. I think it's hard to prove or disprove that statement, 'TIPS pay less in normal times'. They haven't been around all that long, and the period where they have was characterized first by a period where TIPS were a very small exotic asset commanding very high real yields which were in retrospect probably an anomaly (ie boosting historical TIPS realized returns to date), but also a general trend of declining inflation (boosting realized real yields of nominal treasuries relative to TIPS). There's also the 08-09 non 'normal' crisis but as Richard's graph shows the albeit disturbing performance of TIPS during that period soon washed out. Anyway I can't positively refute your statement but see no fundamental reason it would be true in general. My guess would be that over long periods realized TIPS returns would be slightly higher than nominal treasuries in reflection of the lower liquidity. The hypothesis could be tested over a longer period with other countries' inflation adjusted bonds, but that wouldn't be dispositive for TIPS.

2. I agree, mystery, wouldn't jump to say it was an 'efficient' sudden expectation of prolonged deflation that turned around within less than a year, or just the market going haywire, or other things, or a combination. One can only say that TIPS were a hell of a deal in that period in hindsight.

3. I also agree there, to the extent TIPS relative smallness as market is a challenge that's not likely to change dramatically. However once you get away from the issue of liquidity, nominal Treasuries are a poor investment relative to the best CD's (which give much higher yield plus cheap put protection v nominal treasuries), or v going long treasury note futures and putting most of the notional amount in best yielding savings account (better yield, virtually same liquidity, same 'roll effect' v ~constant maturity rolled treasury position, if you can do the futures in tax deferred). But there are no inflation indexed versions of those other trades.

4. We don't know exactly how TIPS would have performed in 70's/80's but IMO it's reasonable to surmise that in the period of most sharply rising inflation and apparent Fed laxity (Miller) TIPS would have far outperformed nominal treasuries which were crushed, though after the turn in the crisis on change to very high Fed real rate policy (Volker) TIPS would have sold off considerably even as nominal treasuries made a come back*. Again in general, if the market believes the Fed will fight unexpected inflation with unexpectedly high real rates, TIPS will sell off on unexpected inflation, just not as much as nominal treasuries of similar maturity will. Therefore getting more yield from shorter duration (ie 5yr CD's, with put protection, matching yield of much longer treasuries), and then transitioning to TIPS *if* inflation kicks up, is a viable strategy IMO. Sounds like 'market timing' but in this particular case it would tend to work I believe. I have some TIPS but more in moderate maturity CD's.

*the key fact we can't know is what would market expectations of *long term* real rates have been when Volker raised the Fed Funds rate to 20% in 1981 with realized inflation at 13.5%. Presumably there'd have been some inverted curve decay function in TIPS real yields, not 6.5% real out to 30 yrs, but still a probably crushing increase in real yield for existing holders of long term TIPS.
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Re: Are TIPS the ultimate inflation hedge?

Post by lazyday »

tarnation wrote:myRA. (worst named program ever)
Should have called it "iRA". no, wait...
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Re: Are TIPS the ultimate inflation hedge?

Post by scone »

^^ Johno

1. I wonder if it's possible to be paid for lower liquidity, but also have to pay an insurance premium, so it nets out more or less to nothing much. Total handwaving here.

2. Agreed, at the time, Larry Swedroe was said to be pounding the table that TIPS were a screaming deal. And no way to tell if it will happen again. I am patiently awaiting Fuld's autobiography, once he's done with court and all.

3. Those types of trades are well over my pay grade, but I can see maybe a ladder of individual TIPS bonds. Except that my husband doesn't want to manage it if I croak. It does look like you get a diversification effect with TIPS and nominals together, so that might be worthwhile in itself.

4. Weirdly, if you put TIPS into the Portfolio Visualizer and compare it to nominals, the drawdowns in the 70s are much worse for TIPS. So is the fault inherent in TIPS, or the synthetic model used by the software? I have no idea.

Oh well. A while back, Taylor said he didn't really understand TIPS either, which made me feel less stupid about them! :mrgreen:
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Re: Are TIPS the ultimate inflation hedge?

Post by kolea »

scone wrote: 4. Weirdly, if you put TIPS into the Portfolio Visualizer and compare it to nominals, the drawdowns in the 70s are much worse for TIPS. So is the fault inherent in TIPS, or the synthetic model used by the software? I have no idea.
I was doing something in PV and got what I thought was a surprising result so I calculated it by hand (well, with Excel) and got a different answer. Maybe it was operator error, maybe a bug. At any rate, it made me nervous so I quit using PV.

As to TIPS - I don't own any but perhaps it is not understanding the benefit of hedging. It seems if you want to inflation protect your investments, you need to be 100% into TIPS. Having 10 or 15% of your assets in TIPS seems like it may help, but not much. I have always believed that equities are the ultimate inflation proof investment and I have a lot of equities anyway, so I feel covered. True, that my fixed income allocation is not inflation immune, but my assumption (and this may be wrong) is that interest rates will rise with inflation, and that short-intermediate duration bond funds will adjust accordingly.
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Re: Are TIPS the ultimate inflation hedge?

Post by Texas Radio »

furwut wrote:
I don't think so. 1) the yield is soooo low; and 2) the CPI is a manipulated almost nonsensical index
The current yield is low because inflation is low.

There is NO evidence that the index is manipulated. Besides the official government figures closely matches Billion Prices Project numbers. Maybe you believe that is manipulated as well? The conspiracy grows!

EDIT
FYI - here is a comparison of CPI versus the BillionPrices Project (BPP)
http://bpp.mit.edu/usa/
CPI manipulation: http://www.investopedia.com/articles/07 ... eindex.asp
http://www.forbes.com/sites/periannebor ... h-the-cpi/
http://www.thestreet.com/story/12006024 ... e-gap.html
http://seekingalpha.com/article/226186- ... -inflation
http://occupywallst.org/forum/understan ... tentional/

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Re: Are TIPS the ultimate inflation hedge?

Post by LadyGeek »

Before this goes any further, Accuracy of the CPI is a political discussion and is off-topic. See: Forum Policy
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Here's why it's political:
U.S. Bureau of Labor Statistics wrote:As an economic indicator. As the most widely used measure of inflation, the CPI is an indicator of the effectiveness of government policy. In addition, business executives, labor leaders and other private citizens use the index as a guide in making economic decisions.
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Re: Are TIPS the ultimate inflation hedge?

Post by Noobvestor »

IIRC Britain and perhaps other places have longer histories with inflation-linked bonds - can't we use such examples to extrapolate likely TIPS behaviors in the US?
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Re: Are TIPS the ultimate inflation hedge?

Post by scone »

TwoByFour wrote:
scone wrote: 4. Weirdly, if you put TIPS into the Portfolio Visualizer and compare it to nominals, the drawdowns in the 70s are much worse for TIPS. So is the fault inherent in TIPS, or the synthetic model used by the software? I have no idea.
I was doing something in PV and got what I thought was a surprising result so I calculated it by hand (well, with Excel) and got a different answer. Maybe it was operator error, maybe a bug. At any rate, it made me nervous so I quit using PV.

As to TIPS - I don't own any but perhaps it is not understanding the benefit of hedging. It seems if you want to inflation protect your investments, you need to be 100% into TIPS. Having 10 or 15% of your assets in TIPS seems like it may help, but not much. I have always believed that equities are the ultimate inflation proof investment and I have a lot of equities anyway, so I feel covered. True, that my fixed income allocation is not inflation immune, but my assumption (and this may be wrong) is that interest rates will rise with inflation, and that short-intermediate duration bond funds will adjust accordingly.
I'd suggest it would be a nice gesture to send the Portfolio Visualizer guys a bug report. I believe they are using the databases developed by the Simba/TrevH backtester project, so there's a connection. These databases aren't perfect, no database is perfect, and the data does not go as far back as we might like-- it is what it is. I use the backtester for personal education-- it has had an influence on my thinking and knowledge, like a good book. But I don't take it as some sort of crystal ball, since of course the future will not look like the past.
"My bond allocation is the amount of money that I cannot afford to lose." -- Taylor Larimore
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