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Mitigating Inflation Risk in Your Retirement Portfolio

Wednesday, 21 Nov 2012 | 10:28 AM ET

To help mitigate the risk that inflation can introduce to a portfolio, you need to be on the defensive. Even modest inflation can erode your retirement savings. It may not be a big worry to you now, but as the economy picks up, so will inflation.

Retirees are disproportionately exposed to rising prices. They're paying for escalating food costs, housing and cars while often on a fixed income. And medical bills can decimate a retirement portfolio, since retirees also pay about three times more for health care than younger investors.

How you position your portfolio to fight inflation is critical. Michael Falcon, head of retirement at J.P. Morgan Asset Management, tells older investors to start early in factoring in higher prices.

Falcon says you should:

  • Consider your investment time horizon to know which asset classes to pick. Most, like stocks, will beat inflation over the long haul, but you can bolster returns and protections by picking the right combination.
  • Make return tradeoffs in your portfolio. Are you willing to sacrifice returns to get better inflation protection? Do the math and strike an appropriate balance. For example, buy some Treasury Inflation-Protected Securities (TIPS) but stay invested in riskier growth stocks.
  • Know your risk tolerance. Inflation-sensitive assets can be very volatile and investors who aren't committed to their plan could panic and sell too soon.

At a minimum, investors need a diversified mix of commodities, TIPS, real estate and equities tied to natural resources and infrastructure to offer them inflation protection, Falcon says.

(Read More: Will 'Fiscal Cliff' Resolution Engulf Social Security?)

Here are three scenarios and suggestions from J.P. Morgan Global Multi-Asset Group that could help you lower the risk of inflation eating away at the purchasing power of your portfolio:

Low Inflation

When inflation is low — whether it is on the rise or is likely to continue to fall — stick with equities. Specifically, choose stocks or mutual funds that invest in natural resources and global infrastructure companies whose products and services will be necessary in a low inflationary environment and also as prices rise.

High (and Falling) Inflation

When inflation is high and on the decline, real estate investment trusts may outperform other asset classes. REITs generate much of their income from rents, which are likely to benefit from high inflation — and should also help your portfolio keep pace as inflation moderates.

High (and Rising) Inflation

When inflation is high and going higher, stick with commodities and TIPS. Hard assets often perform well in periods of high inflation. With TIPS, the principal rises along with inflation.

So a model portfolio to mitigate inflation risk would look something like this:

  • 20% TIPS
  • 40% Inflation-managed bonds
  • 10% REITS
  • 10% Commodities
  • 10% Natural Resources Equities
  • 5% Global Infrastructure Equities
  • 5% Cash

Just keep this in mind: Inflation-sensitive assets can be very volatile. Investors who aren't committed to their financial plan could panic and sell too soon. So make sure you know your tolerance for risk. (Read More: A Smart Start to Retirement Investing)

_ By CNBC's Sharon Epperson; Follow her on Twitter: @sharon_epperson

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