Spread your investments wide to help beat the inflation trap

The consumer prices index (CPI) inflation rate rose to 4 per cent in January, up from 3.7 per cent in December, adding to the pressure on the Bank of England to raise interest rates. The retail prices index (RPI) measure of inflation, which includes mortgage interest payments, rose to 5.1 per cent.

The increase virtually wiped out any lingering chances that savers had of finding a savings account offering returns keeping pace with inflation. CPI of 4 per cent means a basic rate taxpayer needs a savings account paying 5 per cent to maintain their spending power, while higher rate taxpayers need 6.67 per cent. There is no conventional savings account offering those returns and the cash Isa accounts offering 4 per cent or more require the capital to be locked away for at least four years.

Until last summer, many people relied on the tax-free index-linked savings certificates from government-backed National Savings & Investments, but their withdrawal in July removed a key weapon in the battle against inflation. However, smart investing can give you a good chance of ensuring your capital grows in real terms over the long run.

Gilts (government bonds), corporate bonds and stock market-based investments are among the options open to private investors looking to prevent their capital being devalued. These typically involve more risk to capital than savings accounts, although it's important to remember that the impact of inflation means deposits are not necessarily risk-free themselves.

Index-linked gilts guarantee that your initial investment and the interest paid will increase or fall in line with RPI, provided they are held until maturity. More than 1 billion of 12-year index-linked gilts were sold on just one day last week as institutional (such as pension funds) and private investors sought greater inflation protection. But this depends on the rate of inflation, because you may not get a positive return if it drops over the term of the investment.

Paul Lothian, a chartered financial planner at Verus Financial Planning in Dundee, said: "The effective yields of index-linked gilts fluctuate to reflect market expectations of inflation and interest rates, so they don't really provide inflation-proofing over the short or medium term."

There are several funds that specialise in index-linked bonds, in the UK and globally.Adrian Lowcock, senior investment adviser at Bestinvest, likes the global inflation-linked bond fund from Fidelity, which invests in index-linked bonds issued by developed market nations.

A more conventional option is the M&G Inflation Linked Corporate Bond fund, which aims for a return consistent with or greater than UK inflation by investing primarily in index-linked corporate bonds.

The fund can also invest in UK index-linked gilts, and a small proportion of the fund may also be invested in high-yield bonds. Lowcock said: "The majority of total returns will be in the form of capital returns from indexation and income yield from the fund will be low."

There are also several exchange traded funds offering low-cost exposure to inflation-linked bonds, with iShares Barclays the main provider. But the best hedge against inflation may currently be in the form of stock market-based investments and commodities. However, they are a step up the risk ladder and investors need to be aware of the potential for losses.

David Morrans, director of Honour Financial Planning in Edinburgh, said investors are being rewarded for taking a risk. "It could be argued that stocks are currently cheap. Dividend yields on many blue-chips are higher than the corporate bond rate, meaning there should be an up-rating of equity values. This is a view held by Neil Woodford of Invesco Perpetual, and he has shown that he knows what he's talking about."

For those frustrated by a paucity of income from savings products, equity income funds are a good place to start. Tom Munro, director of IFA Tom Munro Financial Solutions, said: "For those investing over the long term looking for a steady income stream, then look no further than the equity income sector, which in my view is where you will achieve reasonably high income levels as well as rising capital over time."

The sector was hit hard last year by the suspension of the BP dividend, where funds and investors rely on a small group of blue-chips for the bulk of their dividends. That's why Munro believes investors needing income should diversify beyond the UK. "In the US, for example, over 92 companies have a record of consecutive dividend increases over the past 25 years, in contrast to only five in the UK over a similar period."

Munro likes the M&G Global Dividend growth fund, which invests in the US (almost 40 per cent of the fund), the UK, France, Brazil, Spain and Canada. Other global funds include the Aberdeen World Growth & Income, Baillie Gifford Global Income and Legg Mason Global Equity Income.

Moving further up the risk scale, commodities and commodities funds have a good track record of outstripping inflation. However, Lothian cautioned: "While their price might match/outstrip underlying UK or global price increases, we know how quickly their value can reverse.Just look at what happened to the price of oil, industrial metals and other raw materials when the global 'meltdown' occurred in late 2008."

This risk can be mitigated to a degree by getting exposure to commodities through natural resources funds that invest in the sector. He recommended the Investec enhanced natural resources fund. "The fund aims for long-term capital growth and is able to go short (sell] and, as such, is expected to exhibit less volatility than a broader commodity index."

But Lowcock noted that the recent strong commodity prices and mining stock valuations mean much of the "easy money" has now been made, with the growth priced in.