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My take on this is that stocks are too risky for investors nearing retirement and even for investors with a longer time frame. The bottom line is you can sleep at night if you invest regularly in inflation protected bonds. While this is certainly true, history shows the returns of stocks are higher over the long term (25+ years) while with TIPS (Treasury Inflation-Protected Securities), the returns are lower, but less risky.

For those nearing retirement TIPS will help preserve principal. For those that are still young, heavy weights in an index fund like Vanguard Wilshire 5000 is smart with a gradual increasing of percentage towards TIPS as you near retirement. It all depends on your, age, risk tolerance, financial goals, how much you think you need in retirement, how much you can afford to invest regularly in a 401K, what your outlook is for the US economy, etc. Lets look at the facts:

• In 1997 the US Treasury began issuing CPI (Consumer Price Indexed) linked bonds to protect investors from inflation. The bonds can be purchased direct over the Internet, through a Mutual Fund such as Vanguard or Fidelity or as an ETF (Exchange Traded Fund).

• I-Bonds are US Treasury securities backed by the full faith and credit of the US Government (because the Uncle Sam has the power to tax), they are sold at face value an grow with inflation-indexed earnings for up to 30 years, are liquid and can be turned into cash at any time after 6-months, you can invest as little as $50 or as much as $30,000 per year, and they have significant tax advantages because you can defer tax on interest for up to 30 years and you don't have to pay state and local taxes.

• TIPS are Treasury Inflation-Indexed Securities similar to I-bonds where the interest rate is set at auction and rates remain fixed throughout the tem of the security. The principal amount is adjusted for inflation but the inflation-adjusted principal will not be paid until maturity. Semiannual interest payments on the inflation-adjusted principal are at the time the interest is paid. TIPS work like other marketable Treasury notes and bonds except that the rate of interest the US Treasury pays is applied to your principal after it has been adjusted in accordance to the CPI. You can avoid paying taxes on TIPS by holding them in a retirement account, such as an IRA or 401K.

• Why is inflation risk such a big deal? Inflation over the last 75 years has averaged 3.17% in the US and has been as low as -10% (known as deflation) during the Depression and as high as 18.2% in 1946. The measure of inflation most often used – and the one used for TIPS, is the Department of Labor's Consumer Price Index (CPI) The CPI is a measure of the average change over time in prices paid by consumers for a fixed market basket of consumer goods and services. The Bureau of Labor Statistics bases the CPI on the prices of about 90,000 items. The purchasing power of a $1.00 is reduced when inflation rears its ugly head, so you have to protect yourself against it when investing for the long term as well as when preserving capital when in retirement.

• How does inflation eat into your long term returns? A sum of $100 invested in a diversified portfolio consisting of all stocks listed on the NYSE in January of 1926 would have increased in value to almost $200,000. This assumes that all dividends received are reinvested. After adjusting for inflation over the same 75 years, the portfolio' value in terms of constant purchasing power increased by far less – only one-tenth as much to $20,000.
• Mutual Funds that offer TIPS:
• American Century Inflation Adjusted Bond Fund (ACTIX)
• BBH Inflation – Indexed Securities (BBHIX)
• Fidelity Inflation-Protected Bond Fund (FINPX)
• GMO Inflation-Indexed Bond Fund (GMIIX)
• PIMCO Real Return Bond Fund (PRRDX)
• Vanguard Inflation – Protected Securities (VIPSX)

TIPS Website:

• Just running the numbers, if you start out with $5,000 in a 401K and put in $100 a month into a stock fund that has a compounded annual growth rate of 9% (the historical US stock average) and adjust for 3% inflation you will have a total pretax return of $88,840 after 25 years. If you start out with $5,000 in a 401K and put $100 a month into a TIPS Mutual Fund that has a compounded annual growth rate of 4% (3% CPI plus 1% interest) you will have a total pretax return of $64,981 after 25 years. The benefit of stock investing is your real rate of return will be higher, but you take on more risk of having to time the market when you need to shift to more conservative principal protected investments at retirement age. The benefit of investing in TIPS is you can sleep at night without having to try and time the market to move into more conservative principal protected investments at retirement age. It all depends on you risk tolerance and time horizon.

Cheers ...
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