One way to protect your portfolio from being eroded by inflation is to investment in Treasury Inflation-Protected Securities (TIPS). They’re Treasury issues so they are guaranteed against default by the U.S. government. Like all Treasuries, the interest paid by TIPS is not subject to state or local income tax.
TIPS are issued in 5-, 10-, or 20-year maturities. You can buy and keep track of them, usually at no cost, at www.treasurydirect.gov. Alternatively, you can invest in a mutual fund or an exchange-traded fund that holds TIPS. However you invest, be prepared to accept a low interest rate–currently, under 2 percent.
While the interest rate is low, TIPS increase in value to keep pace with inflation. If inflation is running at a 4 percent rate, for example, your principal would grow by 4 percent a year. As TIPS principal increases, interest is paid on the inflation-adjusted principal. Therefore, if TIPS have a 2 percent interest rate and inflation is 4 percent while you hold the bond, your total return would be 4 percent + 2 percent = 6 percent.
