Treasury Inflation-Protected Securities are an investment category that can evoke distinctly different reactions from financial planners. Some think they provide valuable portfolio insurance, while others think they are a badly flawed product. But when TIPS are added to actual portfolios, how have they actually performed?

It is indisputable that investment portfolios need a diverse array of assets in order to smooth the pattern of returns. A smoother return pattern results in a lower standard deviation of return over time, which translates into a portfolio with lower risk. The great news is that a well-diversified portfolio that operates with lower volatility does not necessarily have low returns. In fact, broad diversification, while primarily a risk-reducing technique, can also provide attractive performance.

Successful portfolios are built with a variety of assets that have low correlation with one another. For equity-based portfolios, the most common "diversifying" assets are bonds and cash. What happens if TIPS are added to that mix? This study provides an answer for the full 10-year period from 2002 to 2011 by examining an equity-based portfolio in which TIPS, bonds or cash are used as the diversifying asset.

The 10-year correlation between each asset in this study is shown below in the 10-Year Correlations chart. The correlation between U.S. stocks and non-U.S. equities over the past 10 years was 0.9, a very high positive relationship. The correlation between U.S. bonds and TIPS was 0.73.

However, between TIPS and cash, the correlation was minus 0.06. Not surprisingly, the return pattern (which is the driver of correlation) of TIPS is much more similar to bonds than to cash. Based on correlation, cash is a very different asset class from TIPS or U.S. bonds.

Let's now examine the returns of five core assets: U.S. equities, non-U.S. equities, U.S. bonds, TIPS and cash (see the Solo Performance chart below). U.S. equities is represented by SPY, an exchange-traded fund that mimics the S&P 500. Non-U.S. equities are represented by EFA, an ETF that mimics the MSCI EAFE Index. U.S. bonds are represented by LAG, which attempts to replicate the performance of Barclays Capital U.S. Aggregate Bond Index. The performance of TIPS is represented by TIP, an ETF that mimics the Barclays Capital U.S. Treasury Inflation Protected Securities Index. Finally, the performance of cash is represented by Vanguard Prime Money Market (VMMXX).

For ETFs in this analysis that lacked a 10-year history, the missing returns were filled in with the return of the underlying index that the ETF tracks (minus the expense ratio of the ETF).

Our first observation is that, from 2002 to 2011, TIPS outperformed U.S. stocks by 450 basis points, with about one-quarter of the volatility (as measured by standard deviation of annual returns). Despite the fact that U.S. equities outperformed TIPS in six of the past 10 years, the big losses incurred by American stocks during 2002 and 2008 were huge setbacks. By the end of 2011, a $10,000 investment in TIPS had grown to $20,425, versus $13,303 in U.S. equities.

PERILS OF VOLATILITY

Despite the recent virtues of TIPS, it is unlikely that these securities will outperform equities over the long term, such as 20- to 30-year time horizons. But long-term results can be severely damaged by volatility in the short term (periods of less than five years).

This is precisely why assets like bonds, TIPS and cash are included in portfolios. They are performance stabilizers, which ultimately turn out to be performance enhancers (because they help investors stay the course).

Now, to the primary question: How well did these three performance stabilizers do their job when teamed with U.S. stocks and non-U.S. stocks in a simple three-asset portfolio?

As shown in the Team Results chart on page 100, the best performing three-asset portfolio was produced by adding TIPS to a portfolio of U.S. and non-U.S. equities. The 10-year average annualized return was 5.61%. The standard deviation of annual returns was 14.7%, and the terminal value of a $10,000 initial investment was $17,262.

Each asset was equally weighted (33.33% each) and was rebalanced at the end of each year. The comparison portfolio was a 50/50 mix of U.S. stocks and non-U.S. stocks, and was also rebalanced each year.

The all-equities portfolio (50% U.S. stocks and 50% non-U.S. stocks) had a lower return (3.82%) and a much higher standard deviation (21.8%). Adding bonds to an equities portfolio generated a 5.16% annualized return over the 10-year period, while adding cash produced a return of 3.8%. The distinct advantage of adding bonds, TIPS or cash to an equity portfolio is a marked reduction in the standard deviation of return - in other words, a big drop in volatility. Volatility reduction is hard to put a price on. But with 2008 still in our collective memory, we all know it has value.

The simple reality is this: Volatility bothers investors. Sadly, it is often self-inflicted volatility caused by monitoring (in many cases micro-managing) investment accounts far too often. People are prone to monitor - that's just the way it is. If you have clients who don't do that, you're blessed.

The solution for the bulk of your clients is to create a portfolio that doesn't give them a chance to bail out, even if they check it too often. That ideal portfolio is likely to include a portion of TIPS.

Craig L. Israelsen, Ph.D., is a Financial Planning contributing writer and an associate professor at Brigham Young University. He is the author of 7Twelve: A Diversified Investment Portfolio With a Plan.