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Step 6: Fend Off Inflation

MOST BONDS PAY a fixed rate of interest—which means inflation is their mortal enemy. Every tick higher in consumer prices means the interest you earn has less purchasing power.

What to do? You might split your bond portfolio between a total bond market index fund—which will hold mostly traditional fixed-rate bonds—and a fund that focuses on inflation-indexed Treasury bonds. The latter have their principal value stepped up along with the inflation rate, plus you earn a little additional interest on top of that.

Low-cost inflation-indexed bond mutual funds are available from Fidelity Investments and Vanguard Group, while low-cost exchange-traded index funds are offered by BlackRock’s iShares, State Street’s SPDR and Vanguard. You can also purchase individual bonds directly from the government at no cost.

How should you divvy up your money between your total market bond fund and your inflation-indexed Treasury fund? Arguably, they address different economic risks—a total bond market fund will do better when inflation is stable or falling, while inflation bonds will have the edge when consumer prices are rising—so a 50-50 split seems reasonable.

But you might decide it’s prudent to invest less in inflation-indexed Treasury bonds. Yes, they’re perhaps the world’s safest investment, because they are backed by the U.S. government and offer guaranteed inflation protection. But the fact is, inflation-indexed Treasurys are a relatively small part of the overall market and you might prefer to have your holdings look more like the broad U.S. bond market.

Next: Step 7: Tilt Your Portfolio

Previous: Step 5: Build Your Own

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