Investing

Inflation and Deflation: Keeping Your Portfolio Safe

Inflation and deflation are economic factors that investors must consider when planning and managing their portfolios. These two trends are opposite sides of the same coin: Inflation is defined as the rate at which prices of goods and services rise; deflation is a measure of a general decline in the prices of goods and services. Regardless of which trend is unfolding, it’s clear what investors can do to protect their assets — although economies can move quickly from one to the other, making the right steps harder to discern.

key takeaways

  • Investors need to take steps to make their portfolios resistant to inflation or deflation — that is, to protect their assets whether the prices of goods and services rise or fall.
  • Inflation hedges include growth stocks, gold and other commodities, and – for income-oriented investors – foreign bonds and Treasury inflation-protected securities.
  • Deflation hedges include investment-grade bonds, defensive stocks (stocks of consumer goods companies), dividend-paying stocks, and cash.
  • A diversified portfolio that includes both types of investments can provide some level of protection no matter what happens in the economy.

What to Expect in Times of Inflation

Prices tend to go up over time, from a loaf of bread to a haircut to a house. When these increases are excessive, consumers and investors can face difficulties because their purchasing power will rapidly decline. A dollar (or whatever currency you’re dealing with) buys less; that means it’s inherently less valuable.

In the 1970s the United States saw a clear example of soaring inflation. The decade started with mid-single-digit inflation. By 1974, that percentage had risen to more than 12 percent. It peaked at over 13% in 1979.With investors earning mid-single-digit returns on stocks and inflation at twice that, making money in the market is a tough proposition.

Protect your portfolio from inflation

There are several popular strategies to protect your portfolio from inflation.

The first is the stock market. Putting aside the “stagflation” of the 1970s, rising prices are often good news for the stock market. Growth stocks grow as the economy expands.

Treasury Inflation-Protected Securities (TIPS) are a common choice for fixed-income investors looking for an income stream that keeps pace with rising prices. These government-issued bonds guarantee that their face value will rise with inflation, as measured by the consumer price index, while interest rates will remain unchanged. Interest on TIPS is paid semi-annually. These bonds can be purchased directly from the government in $100 increments through the Treasury Direct System, with a minimum investment of $100 and maturities of 5, 10, and 30 years.

International bonds also provide a way to generate income. They also provide diversification, allowing investors to enter countries that may not experience inflation.

Gold is another popular inflation hedge because it tends to maintain or increase its value during periods of inflation. Other commodities can also be put in this bucket, as can real estate, as these investments tend to appreciate in value when inflation rises. When it comes to commodities, emerging market countries often generate significant revenue from commodity exports, so adding stocks from these countries to your portfolio is another way to brand your commodity.

What to expect in times of deflation

Deflation is less common than inflation. It can reflect a surplus of goods or services in the market. It can also happen when a lower level of demand in the economy causes prices to fall excessively: periods of high unemployment and depression often coincide with deflation.

Japan’s lost decade (1991-2001) highlighted the devastation of deflation. The era began with the collapse of the stock and real estate markets.This economic collapse has caused wages to fall. Falling wages reduce demand, which in turn causes prices to fall. Lower prices lead to expectations that prices will continue to fall, so consumers delay purchases. The lack of demand causes prices to fall further and the downward spiral continues. Combined with interest rates hovering around zero and the yen’s depreciation,and economic expansion came to an abrupt end.

Protect your portfolio from deflation

When deflation is a threat, investors defend by favoring bonds. High-quality bonds tend to outperform stocks during deflationary periods, which bodes well for the popularity of government-issued bonds and triple-A corporate bonds.

When it comes to stocks, companies that make consumer products that people have to buy anyway (think toilet paper, food, medicine) tend to do better than others. These are often referred to as defensive stocks. Dividend-paying stocks are another consideration in the equity universe.

Cash has also become a more popular method of holding. In addition to regular old savings accounts and interest-bearing checking accounts, there are cash equivalents: certificates of deposit (CDs) and money market accounts — very liquid assets.

You can provide inflation or deflation proof to your portfolio in a number of ways. While building it safely one by one is always an option, investing in mutual funds or exchange-traded funds offers a convenient strategy if you don’t have the time, skills, or patience for a security-level analysis.

Inflation and Deflation Planning

Sometimes it’s hard to say that inflation or deflation is the bigger threat. When you don’t know what to do, plan for both. A diversified portfolio of investments that thrive in times of inflation and those that thrive in times of deflation can provide a degree of protection no matter what happens in the economy.

Diversification is key when you don’t want to try and time the inflation/deflation cycle properly. Blue-chip companies tend to be able to withstand deflation and pay dividends, which can help when inflation rises to the point where valuations stagnate.

Diversifying overseas is another strategy, as emerging markets are often exporters of in-demand commodities (hedge against inflation) and have imperfect linkages to the domestic economy (protect against deflation). High-quality bonds and the aforementioned TIPS are reasonable choices in fixed income. With TIPS, you are guaranteed to get back at least the value of your initial investment.

Time frame also plays an important role. If you have 20 years to invest, you probably have time to weather any type of downturn. If you’re about to retire or live on portfolio-generated income, you may not be able to wait for a recovery and have no choice but to take immediate action to adjust your portfolio.

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