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I am wondering what type of investment offers the least amount of overall risk. I know that Money Market accounts and CD's offer a low risk of reducing the principal. But they earn such low rates that inflation risk starts to become a concern. (If the investment yield doesn't beat inflation then the investment is losing value.) Of course stocks and aggressive mutual funds have a lower inflation risk, but a higher risk overall.

So where is the middle ground that minimizes the chance of my investment losing its inflation adjusted value?

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I would say a diversified conservative balanced fund (perhaps 80% bonds, the rest equities). This historically keeps up with inflation, though in the short term it can definitely fluctuate downward some years. The more diversification the better, say into international stocks and other major asset classes.

The 80/20 average historical annual return is 6.7% nominal (before inflation), which is higher than historical inflation: https://personal.vanguard.com/us/insights/saving-investing/model-portfolio-allocations

Bonds alone would generally be less reliable than bonds plus 10-20% in stocks. You may be able to go as much as 90% bonds if the goal is absolute minimum risk. I've read in more than one place that 100% bonds averages lower returns with more risk than 90/10, so 100% bonds would be an inferior option historically, compared to diversifying just a bit into equities.

You could argue that TIPS (or other inflation-indexed bonds) are the guaranteed way to beat inflation with no additional risk. I would personally feel more comfortable with a balanced portfolio diversified across thousands of stocks and bonds around the world:

  • TIPS are country-specific, and however remote the chances, there are probably risk factors unique to US government securities
  • while I don't subscribe to conspiracy theories about the consumer price index (CPI), it is in some ways arbitrary and its definition of inflation may not line up with your actual expenses; a diversified portfolio avoids "inflation definition risk" a bit more perhaps
  • because an 80/20 portfolio does a little better than inflation historically, maybe you have some more margin for error

You can always keep some money in cash or near-cash (very short-term bonds), in addition to the balanced portfolio, to lower risk and returns down to the desired point.

Commodities and metals often come up when talking about inflation risk; the problem is that these are so volatile, you'll have big timing problems - if you buy at a wrong (too high) time you could wait decades to get your principal back. So I don't think these make sense for the goal you described. See also What would be the signs of a bubble in silver?

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    Note that (in the US) TIPS are also taxable. If you're not investing in a tax shelter (IRA/401(k)/etc), you're going to lose money from the taxes on the "just keeping up with inflation" portion. Also note that inflation also sees interest rate increases, so the face value of your TIPS may fall and you may lose money if you don't hold them to maturity.
    – user296
    May 19, 2011 at 1:40

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