Watching the World Cup in South Africa these past few weeks, I realized there are many parallels between winning World Cup soccer games and investing with an eye toward inflation protection.

There are times to be bold and aggressive in both World Cup soccer and investing, but these moments are often fleeting and unexpected. Just as with building long-term portfolios to protect against the damaging effects of inflation, the most successful soccer teams play excellent defense, cover the entire field, and have patience.

In a previous article (“Inflation vs. Deflation: Prepare for Either”), I discussed how different investments have tended to track changes in the Consumer Price Index (CPI), and analyzed the pattern of 12-month rolling asset class returns in periods of high and low inflation. With its discussion of shorter time frames, that article was geared toward helping investors weigh near-term strategies for either inflation or deflation.

But what about longer-term options to help protect investors’ portfolios from the insidious damage of long-term price increases?

A long history of rising prices

From January 1926 to May 2010, there have been 894 rolling 10-year periods. Of these, prices (as measured by the CPI) rose in 92% of the 10-year periods. However, the 69 periods that saw negative inflation all occurred between 1935 and 1941. There have been no five-year periods with negative inflation since 1937. So, unless the economy returns to the dark days of the Great Depression, the trend over the past 70+ years suggests that prices will continue to rise.

The steady erosion of purchasing power from inflation is of particular concern to investors who will need to rely on their retirement savings to fund the bulk of their retirement income needs. A long-term increase in inflation that is not at least matched by an increase in portfolio returns can have serious consequences for retirement income planning. Therefore, when analyzing investment options specifically targeted to help fund retirement income needs, it can help to focus on the real performance of different asset classes—that is, investment returns after subtracting the inflation rate. Before we delve into long-term inflation protection options, keep in mind that an investment’s demonstrated ability to react to changes in inflation should be considered within the context of an investor’s risk tolerance, time horizon, and investment goals.

Keeping up with inflation protection

So, how should long-term investors emulate the best World Cup soccer teams and play defense against rising prices? Regardless of whether inflation is high or low, one of the primary goals of any long-term inflation-protection strategy is to outperform the rate of inflation—not necessarily shooting for the goal at every chance and trying to achieve the highest absolute returns. While past performance doesn’t guarantee future results, there are two broad-based categories of asset classes that have tended to hold up relatively well during inflationary climates: financial securities that adjust their return for inflation, and tangible, physical assets such as commodities and real estate.

Treasury Inflation-Protected Securities (TIPS) are designed to adjust to changes in inflation.¹ Commodities are the raw materials input for many consumer expenditures, such as food, fuel, cars, and housing, and may offer some protection from the erosion of purchasing power caused by inflation. Another potential source of inflation protection is commercial real estate—such as apartment buildings, office towers, and shopping malls—which can be owned by individual investors through real estate investment trusts (REITs). Real estate securities such as REITs can offer inflation protection because changes in the CPI are often factored into rent increases.

The inflation-fighting power of TIPS

The table below shows the average 10-year rolling real returns, dating back to 1926, for 10 asset classes. If an investor’s primary goal had been to achieve a positive real return with the least amount of downside risk, then, not surprisingly, the best choice would have been TIPS, had they existed. Since being introduced in 1997, TIPS have had no rolling 10-year periods where the real return was negative. Also, the range of real returns were in a relatively narrow band, with the lowest return over any 10-year period being an average annual return of 3.0%; the highest average annual return for any 10-year period was 4.7%.

While historical returns can provide some useful insights, it is important to remember that past performance patterns may not be repeated in the future. Further, TIPS have only been in existence for a total of 13 years, so there is much less history to analyze compared with the other asset classes on this list. In addition, the total return on TIPS is a function of both actual realized inflation and bond market investors’ expectations for future inflation. Therefore, over shorter-time periods, changes in inflation expectations can produce subpar or negative real returns even when the actual rate of trailing inflation is positive. However, over longer time periods (such as the 10-year rolling periods shown in the table above), TIPS have performed as designed and have provided inflation protection. Therefore, investing in TIPS has clearly been beneficial for investors focused on investments that have kept pace with inflation over the longer term.

Commodities and real estate: Also historically strong inflation-fighters

For others looking for inflation protection over a longer-term horizon who are also willing to accept some degree of volatility and risk, options such as real estate and commodities have also demonstrated an ability to outperform inflation.

From January 1972 to May 2010, real estate securities had no rolling 10-year periods with a negative real return. Further, the average annual real return for real estate securities was 8.1%, more than twice that of TIPS. The next two asset classes with the lowest percentage of rolling 10-year periods with negative real returns were commodities (5%) and U.S. small-cap stocks (6%). Foreign stocks (12%), U.S. large-cap stocks (15%), and high-yield bonds (15%) had a similar amount of negative real return periods.

Bonds and T-bills: Historically better when inflation is low or falling

Nominal bonds and Treasury bills have tended to underperform inflation at a similar pace even as the time horizon lengthens. The chart below shows that long-term corporate bonds have done a worse job fighting inflation as the time horizon grows longer. They had a positive real return in 66% of the rolling 12-month periods, but in only 62% of the rolling 10-year periods. Treasury bills outpaced inflation at about the same rate, beating inflation in only 64% of both the rolling 12-month and rolling 10-year periods.

However, before dismissing bonds as a subpar investment vehicle for inflation protection, keep in mind that in deflationary and low inflation environments, bonds have performed well. In the deflationary period of the 1930s, long-term corporate bonds were standout performers. This was not a one-time historical aberration, as long-term corporate bonds were the second-best-performing asset class (of the ten analyzed in this paper) during the decade of the 2000s. Further, when the rolling three-year return periods since 1974 are sorted into equal quintiles based on inflation rates, long-term corporate bonds emerge as the top performer in the lowest quintile of inflation.

Seeking inflation protection over the short and the long term

Few people may have the nerve or conviction to wait 10 years for their portfolio results. So, it helps to look at how different asset classes have protected against inflation across shorter time lengths. The table below shows the percentage of time that different asset classes have had real returns greater than zero (positive returns after subtracting the rate of inflation) across rolling 12-, 36-, 60-, and 120-month periods.

TIPS outperformed inflation the most frequently across both short and longer-term time periods. The real total return for TIPS was positive in 84% of the rolling 12-month time periods and jumped to 96% for the rolling three-year periods. There were no rolling five-year or 10-year periods where TIPS had a negative real return. Of course, TIPS have only been in existence for 13 years, so there is much less history to analyze than with the other asset classes.

Real estate securities and commodities have also beaten inflation over the longer term. Real estate securities outperformed inflation in 100% and commodities beat inflation in 95% of the rolling 10-year periods dating back to the 1970s. At least one caveat, however, should be kept in mind: while real estate, commodities, small-cap stocks, foreign stocks, large-cap stocks, and high-yield bonds all had a positive real return in at least 85% of the rolling 10-year periods, there was not much difference in their abilities to beat inflation over the rolling 12-month periods; all had positive real returns in only 64–69% of the rolling 12-month periods.

Do you have a plan to defend against inflation?

While investing in real estate or commodities may provide some protection against the ravages of inflation, these asset classes also expose participants to increased portfolio volatility. Therefore, a sensible strategy is to make potential inflation protection options as diversified as possible—such as with a multi-asset-class real return mutual fund. A multi-asset-class real return fund can offer exposure to a variety of asset classes, including real estate investment trusts (REITs), commodities, and TIPS. Combining these investment categories into one fund still offers potential protection against inflation, but with less potential volatility than investing in a pure real estate or commodities fund might.

At the moment, inflation does not look to be an immediate concern. Substantial slack in the economies of the United States and other developed nations is keeping a lid on upward pricing pressures. However, as World Cup soccer has shown, the time to mount a strong defense is not at the moment just before the opposing team kicks a goal. Likewise, it pays to plan ahead and consider your options well before the moment when inflation has already arrived at the cash register.

© 2010 Fidelity Investor's Publications

Before investing in any mutual fund, please carefully consider the investment objectives, risks, charges, and expenses. For this and other information, call or write Fidelity for a free prospectus or, if available, a summary prospectus. Read it carefully before you invest.

The information presented above reflects the opinions of Bill Ralls, senior vice president of research, as of July 2, 2010. These opinions do not necessarily represent the views of Fidelity or any other person in the Fidelity organization and are subject to change at any time based upon market or other conditions. Fidelity disclaims any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for a Fidelity fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity fund.

Past performance is no guarantee of future results.

Investing involves risk, including risk of loss.

Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.

In general the bond market is volatile, and bond funds entail interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Bond funds also entail the risk of issuer or counterparty default, issuer credit risk, and inflation risk.

Changes in real estate values or economic conditions can have a positive or negative effect on issuers in the real estate industry, which may affect a fund containing real estate investments.

1. TIPS are designed to track changes in the monthly Consumer Price Index (CPI), as reported by the Bureau of Labor Statistics. If the CPI rises, the securities’ principal, or face value, increases. The coupon rate for TIPS is constant, but generates higher interest when the inflation-adjusted principal rises. When the securities mature, investors get back the CPI-adjusted principal.

Inflation is represented by the Consumer Price Index for All Urban Consumers (CPI-U), not seasonally adjusted, as calculated by Ibbotson Associates. CPI-U is a broad measure of the rate of change of consumer goods prices and is calculated by the U.S. Department of Labor, Bureau of Labor Statistics (BLS). Ibbotson Associates estimates the most current month by taking the average CPI-U rate of the previous two months. Source: Ibbotson Associates; U.S. Department of Labor, Bureau of Labor Statistics; data from January 1926 to May 2010.

Large-cap stocks are represented by the Standard & Poor’s 500 Index (S&P 500®). The S&P 500 is an unmanaged market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance. Prior to March 1957 the index consisted of only 90 of the largest stocks. Source: Ibbotson Associates; Standard and Poor’s; data from January 1926 to May 2010.

Small-cap stocks are represented by the Ibbotson Associates U.S. Small Company Stock series from January 1926 to December 1978 and the Russell 2000 Index thereafter. The Small Company Stock return series is composed of stocks making up the fifth quintile of the New York Stock Exchange (NYSE). The Russell 2000® Index is an unmanaged market capitalization-weighted index of 2,000 small company stocks of U.S. domiciled companies. Source: Ibbotson Associates; Frank Russell.

High-yield bonds are represented by the Barclays U.S. Corporate High Yield Index from January 1926 to August 1986, the Merrill Lynch U.S. High Yield Master II Index from September 1986 to December 1996, and the Merrill Lynch U.S. High Yield Master II Constrained Index thereafter. Source: Ibbotson Associates; Barclays Capital; Merrill Lynch. The Merrill Lynch U.S. High Yield Master II Index is an unmanaged market-value-weighted index of all domestic and Yankee high-yield bonds, including deferred interest bonds and payment-in-kind securities. The Merrill Lynch U.S. High Yield Master II Constrained Index is a market value-weighted index of all domestic and Yankee high-yield bonds, including deferred interest bonds and payment-in-kind securities. It limits any individual issuer to a maximum of 2% benchmark exposure.

Long-term corporate bonds are represented by the Ibbotson Associates Long-Term Corporate Bond series from January 1926 to December 1972 and the Barclays Capital U.S. Long Credit Index thereafter. The Barclays Capital Long Credit Bond Index is an unmanaged market value-weighted performance benchmark for corporate fixed-rate debt issues with maturities greater than 10 years. Source: Ibbotson Associates; Barclays Capital.

Intermediate-term government bonds are represented by the Ibbotson Associates Intermediate-Term Government Bond series from January 1926 to December 1972 and the Barclays Capital Intermediate Treasury Index thereafter. The Barclays Index includes all publicly issued, U.S. Treasury securities that have a remaining maturity of greater than or equal to 1 year and less than 10 years, are rated investment grade, and have $250 million or more of outstanding face value. Source: Ibbotson Associates; Barclays Capital.

Treasury bills are represented by the Ibbotson Associates U.S. 30-Day Treasury Bill series from January 1926 to December 1990 and the Barclays Capital 1–3 Month Treasury Bill Index thereafter. The Barclay Capital Treasury Bill Index includes all publicly issued zero-coupon United States Treasury bills that have a remaining maturity of less than three months and more than one month, are rated investment grade, and have $250 million or more of outstanding face value. Source: Ibbotson Associates; Barclays Capital.

Commodities are represented by the S&P/Goldman Sachs Commodity Index (S&P GSCI®) from January 1970 to December 1990 and the Dow Jones-UBS Commodity Index thereafter. The S&P GSCI is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The Dow Jones-UBS Commodity Index is a broadly diversified index that allows investors to track commodity futures through a single, simple measure. It is composed of futures contracts on physical commodities.

Foreign stocks are represented by the Morgan Stanley Capital International Europe, Australasia and Far East (MSCI EAFE) Index, which is an unmanaged market capitalization-weighted index of equity securities of companies domiciled in various countries. The index is designed to represent performance of developed stock markets outside the United States and Canada and excludes certain market segments unavailable to U.S.-based investors.

Real estate securities are represented by the FTSE NAREIT Equity REIT Index from January 1972 to December 1977 and the Dow Jones U.S. Select Real Estate Securities Index thereafter. The FTSE NAREIT Equity Index is an unmanaged index representing equity REITs. The Dow Jones U.S. Select Real Estate Securities Index measures U.S. publicly traded real estate securities. It screens for market cap, liquidity and percentage of revenue derived from ownership and operation of real estate securities. Source: Ibbotson Associates; FTSE; Dow Jones.

TIPS are represented by the Barclays Capital U.S. Treasury Inflation-Protected Securities (TIPS) Index from March 1997 to January 1999 and the Barclays Capital 1–10 Year U.S. Treasury Inflation-Protected Securities (TIPS) Index thereafter. Source: Ibbotson Associates; Barclays Capital.

All indexes are unmanaged and performance of the indexes include reinvestment of dividends and interest income, unless otherwise noted. The indexes are not illustrative of any particular investment and it is not possible to invest directly in an index.

Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917.

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