Inflation and deflation are economic factors that investors must consider when planning and managing their investment portfolios. These two trends are two sides of the same coin: Inflation is defined as the speed at which the prices of goods and services rise; and deflation is an indicator of the general decline in the prices of goods and services. Regardless of the trend, the steps investors can take to protect their holdings are clear-although the economy can quickly move from one to another, this makes the correct steps more difficult to discern.
- Investors need to take steps to prevent inflation or deflation in their investment portfolios—that is, to protect their assets regardless of whether the prices of goods and services rise or fall.
- Inflation hedges include growth stocks, gold and other commodities, as well as—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.
- Regardless of economic conditions, a diversified portfolio of two types of investments can provide a certain degree of protection.
What to expect in times of inflation
Over time, prices tend to rise, from a loaf of bread to a haircut to a house. When these growths are excessive, consumers and investors may face difficulties because their purchasing power will decline rapidly. One dollar (or whatever currency you trade) buys less; this means it is inherently less valuable.
A clear example of soaring inflation occurred in the United States in the 1970s. This decade began with mid-single-digit inflation. By 1974, this proportion had risen to more than 12%. It reached a peak of over 13% in 1979.Since investors get mid-single-digit returns from stocks, and the inflation rate is twice this number, making money in the market is a difficult proposition.
Protect your investment portfolio from inflation
There are several popular strategies to protect your investment portfolio from inflation.
The first is the stock market. Leaving aside the “stagflation” of the 1970s, price increases are often good news for stocks. Growth stocks grow as the economy expands.
For fixed-income investors looking for a source of income that keeps pace with rising prices, Treasury Inflation Protected Securities (TIPS) is a common choice. These government-issued bonds guarantee that their face value will rise with inflation as measured by the consumer price index, while their interest rates will remain unchanged. The interest of TIPS is paid every six months. These bonds can be purchased directly from the government in increments of 100 US dollars through the direct system of the Ministry of Finance, with a minimum investment of 100 US dollars and maturities of 5 years, 10 years, and 30 years.
International bonds also provide a way of generating 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 appreciate during inflation. Other commodities can also fall into this category, as can real estate, because these investments tend to appreciate when inflation rises. In terms of commodities, emerging market countries usually earn considerable income from commodity exports, so adding stocks from these countries to your portfolio is another way to brand a commodity.
What to expect in a period of deflation
Deflation is less common than inflation. It can reflect the surplus of goods or services in the market. This can also happen when a lower level of demand in the economy causes prices to fall excessively: periods of high unemployment and depression usually coincide with deflation.
Japan’s lost ten years (from 1991 to 2001) highlighted the ravages of deflation. This era began with the collapse of the stock market and real estate market.The economic collapse caused wages to fall. Falling wages lead to reduced demand, which in turn leads to lower prices. Lower prices lead to expectations that prices will continue to fall, so consumers postpone their purchases. Insufficient demand has caused prices to fall further, and the downward spiral continues. Coupled with interest rates hovering near zero and the depreciation of the yen,And economic expansion came to an abrupt halt.
Protect your investment portfolio from deflation
When deflation becomes a threat, investors prefer bonds for defense. During periods of deflation, high-quality bonds tend to outperform stocks, which indicates the popularity of government-issued bonds and AAA corporate bonds.
In terms of equity, companies that produce consumer products that people must buy anyway (such as toilet paper, food, and medicine) tend to perform better than other companies. These are often referred to as defensive stocks. Dividend-paying stocks are another consideration in the stock sector.
Cash has also become more popular. In addition to ordinary old savings accounts and interest-bearing checking accounts, there are cash equivalents: certificates of deposit (CD) and money market accounts-highly liquid assets.
There are many ways you can prevent inflation or deflation in your investment portfolio. Although it is always an option to safely build it one by one, if you don’t have the time, skills, or patience to perform a security level analysis, investing in mutual funds or exchange-traded funds will provide a convenient strategy.
Plan for inflation and deflation
Sometimes it is difficult to judge whether inflation or deflation is the greater threat. When you don’t know what to do, plan for both. Regardless of the economic situation, a diversified investment portfolio, including those that thrive in periods of inflation and those that thrive in periods of deflation, can provide a certain degree of protection.
Diversification is the key when you don’t want to try to correctly time the inflation/deflation cycle. Blue chip companies often have the ability to withstand deflation and pay dividends, which helps when inflation rises to the point where valuations have stagnated.
Diversification abroad is another strategy, because emerging markets are usually exporters of goods in demand (hedging inflation) and are not fully connected to the domestic economy (preventing deflation). High-quality bonds and the aforementioned TIPS are reasonable choices for the fixed income side. With TIPS, you can at least guarantee the value of your original investment.
The time frame also plays an important role. If you have 20 years of investment time, then you may have time to weather various recessions. If you are about to retire or live on the income generated by your investment portfolio, you may not be able to wait for the recovery, and you have no choice but to take immediate action to adjust your investment portfolio.