Scary economy, real solutions

Solution: Invest in inflation hedges

Treasury Inflation-Protected Securities, or TIPS, are the one guaranteed hedge against rising prices. With TIPS, your principal is adjusted upward every six months to keep pace with the consumer price index. The bonds carry a fixed coupon rate lower than that of Treasuries of similar maturity. But the dollar amount of the payment increases as your principal value is adjusted upward.

Another way to beat inflation is to own the stuff that's going up in price. Between 1973 and 1981, when inflation averaged 9%, the Goldman Sachs Commodity Index, which tracks oil, metals and food futures, averaged a 13% annual return.

Real estate earned its reputation as an inflation hedge in the 1970s, when home values and commercial property climbed along with food and energy. But these days everyone knows that real estate is the one thing that isn't going up. So how can there still be a case for REIT (real estate investment trust) funds? REITs own commercial property and apartment buildings, not houses. Landlords should have some power to raise rents along with inflation. And like commodities, REITs have the diversification advantage of moving out of step with stocks. For the long term, it's reasonable to keep less than 10% of your portfolio in REITs.

When it comes to inflation, timing matters. The longer your time horizon, the less you need to rely on inflation fighters like TIPS, commodities and REITs. But as you draw closer to retirement, you'll want to gradually boost your allocation to those assets that fight inflation most directly. --Penelope Wang

NEXT: Exploding gas prices