MONDAY MORNING: Here’s a Tip on asset diversification

It’s hard to get excited about a risk-free return of 4.72% a year at a time when the market has been returning 20% or more for five years and inflation is at a relatively benign 3%.

But these halcyon days must end sometime. Storms may strike with little warning, so every investor should have a storm sail in the portfolio.

There is an asset class that can weather the roughest storm on Wall Street.

It has almost zero correlation with domestic stocks, 10-year Treasury bonds and 30-day Treasury bills, and it’s not a foreign investment.

index to inflation

It’s Tips — Treasury inflation-protected securities. Tips are nothing more or less than bonds whose return is indexed to inflation so that they guarantee a real rate of return.

When added to a portfolio, they raise the efficient frontier, giving a higher real return for each unit of risk. Yet very few investors are using them.

More should, according to Roger Ibbotson, chairman of Ibbotson Associates in Chicago, which consults on asset allocation and tracks the long-term investment returns of various asset classes.

As of Oct. 31, the total market value of Tips was $100.1 billion, a minuscule part of the total outstanding government debt, which stood at $5.6 trillion.

According to Mr. Ibbotson, Tips are a bargain. An investor has to give up only about 2% of yield to receive protection against inflation, which is running about 3% per year.

“This is a wonderful asset class,” Mr. Ibbotson said last week. “People buy 10-year or 30-year bonds, and there is a real possibility you might have substantial inflation over that period of time.

“These bonds protect you from that. You get a real rate of return and inflation protection of the principal value. No other asset class acts anything like this.”

stocks, bonds both fare badly

The evidence is that both stocks and bonds do poorly in inflationary periods. “Tips are a hedge against this,” he said.

In effect, Tips are an insurance policy against the return of inflation.

If inflation does not return, then the investor has unnecessarily accepted the costs of the lower return offered by Tips. Still, as Mr. Ibbotson pointed out, we don’t think about the insurance premiums we paid when catastrophes don’t happen.

But perhaps the greatest value of Tips is the fact that they are a diversifying asset class.

An analysis by Ibbotson Associates shows that adding Tips to a portfolio mix will increase the real return for each level of risk (as measured by standard deviation).

A portfolio using Tips will have lower allocations to conventional bonds and cash than portfolios not using Tips, the study showed.

Mr. Ibbotson believes that at the slightest hint of more inflation the demand for Tips will pick up.