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Step 7: Silent Partners

Figure 7-4

Inflation Unlike investment costs and taxes, inflation is an uncontrollable variable. To hedge inflation risk, investors may buy Treasury Inflation-Protected Securities (TIPS) which adjust their coupon payments and re-payment of principal based on the Consumer Price Index (CPI). While TIPS may seem an obvious choice, investors should not forget free protection from risk does not exist. This protection comes with a lower long-term expected return relative to nominal bonds. A TIPS buyer bets that actual inflation will be higher than the “breakeven inflation� incorporated into TIPS prices. One way to mitigate inflation risk is to keep bond maturities short because market interest rates will reflect expected inflation, and as these bonds mature, they can be re-invested at the higher market interest rates. Another way is to invest in asset classes that have expected returns in excess of inflation.

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