Inflation and deflation are two sides of the same coin; while inflation is the increase in prices of goods and services over time, deflation is the opposite; it is an inflation rate below zero percent that depicts a decline in the prices of goods and services. The economy can turn inflationary or deflationary with equal measure. Effectively planning for each cycle by readjusting your portfolio is essential for investors. Inflation-or- deflation-proofing your portfolio will keep your wealth safe from the cyclical change in prices typical with inflation and deflation.
The most common inflationary assets include growth stocks, gold and commodities, foreign bonds, and Treasury Inflation-Protected Securities because they historically perform well when prices and rates increase. On the flip side, deflationary assets are investment-grade bonds, defensive stocks, dividend-paying stocks, and cash because their value holds off much longer in deflation or increase in value, as is the case for cash. If your portfolio contains a mix of the two classes, it offers somewhat reliable protection from whatever tide the economy takes.
Inflationary assets
When inflation hits, the prices of goods and services soar excessively. This also corresponds to a reduction in the value of the currency and the reduced purchasing power of the citizens. The same amount of money that could buy a loaf of bread would be unable to buy it because the money is technically worthless. The US was hit with inflation way back in the 1970s where inflation was in the double digits. Making good returns was hard because inflation outnumbered the stock returns making actual returns sink even lower.
Protecting your portfolio with inflationary assets is the best way to survive the uptick of inflation. Some of the common inflationary assets to get include;
Growth stocks
They offer gradual growth with payouts at a later date rather than immediately. A hike in prices is good for equities, especially with growth stocks of companies growing along with an inflationary economy expected to increase in value over time. They can be considered as a store of value.
Treasury Inflation-Protected Securities (TIPS)
They are a common feature of most portfolios of fixed-income investors who want to stay afloat amidst rising prices. The advantage of TIPS is that they are bonds issued by the government. They have a guarantee of a rising value matching the CPI with a fixed interest rate. TIPS pays their interest semi-annually and can be purchased directly via the Treasury Direct System. You have the option of 5-, 10-, and 30- year maturities.
International bonds
For investors with an appetite for venturing beyond the walls, international bonds can be a great fit. They allow you to diversify your portfolio and invest in several other countries which may not be experiencing inflation or similar economic difficulties as your domestic economy.
Gold and commodities
In the past, gold has shown its ability to retain or increase in value when inflation hits. You can get gold bullions or trade in stocks of companies that deal with gold mining. Commodities have also shown promise during inflation, but it takes a bit more effort to pick suitable commodities. During inflation, commodity exports generate lots of revenue for the countries and companies. You can choose to trade the stocks from those countries or the commodity itself.
To be on the safe side, have some or all of these assets on your portfolio. Individually, they have a reduced chance of holding up your wealth; gold is expensive, and it doesn’t have that much yield with its faltering prices. Commodities struggle to maintain their prices and keep up with demand. A foreign bond is only liable if inflation doesn’t spread and affect the countries’ economy.
Deflation
Deflation is uncommon compared to inflation. Deflation occurs when the reduced level of demand in the economy forces prices to drop excessively across the board. The reduced level of demand could be due to unemployment and retrenching or even failed wages, the characteristics of an economic depression.
When prices decline, consumers are reluctant to make purchases, expecting that the prices will keep falling. They hold off in hopes of even lower prices, reducing the income for companies and forcing them to reduce their workforce. This reduces the number of people with enough money and offsets another negative feedback loop. A notable example of deflation is Japan’s “lost decade,” They suffered deflation with widespread unemployment and even lower prices and spending.
Deflation is easily confused with disinflation. The difference, however, is that deflation is a decrease in the prices of goods and services, while disinflation is a decrease in the rate of inflation. For an item that costs $10, a 2% deflation would mean it is now worth $9.80, while a 2% disinflation means you can buy it for $10.20 and not $10.40 if the annual inflation rate is 4%.
Deflationary investing leans more in favor of investments & assets that pay off in regular intervals at a fixed rate. Some of the assets that perform well during disinflation include;
Defensive stocks
Despite a reduction in consumer spending, there are essential commodities that people must buy; healthcare, electricity, food, and drugs. Companies dealing in said commodities tend to hold up well during deflation. These are defensive stocks because these items will hold their position no matter how low the prices sink.
The Fed will exercise a monetary policy to counter the effects of inflation. This will include lowering the interest rates across the board. When choosing assets to invest in, those that flourish and thrive when interest rates are slipping will do great during deflation. You can try Long-term bond funds, Zero-coupon bond funds, and dividend funds if you require some safety. If you want a little risk, try precious metal funds or money market funds.
Cash and liquid holdings
Savings accounts and high-interest checking accounts perform well during deflation. Other liquid holdings like Certificates of Deposits also survive deflation. A significant advantage of having cash during inflation is that the credit market shrinks. The interest rates are hiked, making loans more expensive in terms of their interest payments.
Gold can also be an excellent asset for deflation because, compared to other industrial metals like silver and steel, whose demand declines as production slows down.
Diversifying your survival pack
Deflation investing should focus more on capital preservation over high yields. It can be hard to predict which turn the economy will take, and for investors, going in blind and winging it is generally a bad idea. Diversifying your portfolio with both inflation- and deflation-proof investments gives you the best of both worlds and reliable protection for whichever trend the economy takes. When you can’t accurately determine which cycle comes next, investing on both sides comes in handy.
Diversification also includes venturing outside the comfort zone. Hold assets in other countries with stable inflation rates and high yields. These economies could be a significant hedge when the domestic economy tanks and import prices skyrocket. Depending on how much time you have left to invest, you can accurately time your stock portfolio to include inflation-proof growth stocks or go the cash way to settle in for the deflation. Adjusting your portfolio to meet your timing needs is crucial.
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