Investment Tip – How to Invest


 

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Investing Tip of the Month from Morningstar Investment Research Center

How to Invest in a Deflationary Environment

By Christine Benz, Director of Personal Finance

Question: I’ve been reading a lot about deflation recently and am worried. Will any investments hold up well in a deflationary environment?

Answer: Although inflation grabbed all the headlines less than a year ago, it’s downright tame right now. Instead, some market participants are concerned that we could confront a period of declining prices as the government’s stimulus package winds down, particularly if unemployment stays high and the housing market stays in the doldrums. Some investors, such as DoubleLine’s Jeffrey Gundlach, have argued in the past that deflation could be a near-term problem, followed by high inflation rates down the line.

Why It Hurts
At first blush, declining prices for stuff may not sound that bad, particularly for consumers who might be able to take advantage of lower prices for everything from groceries to LCD televisions. But a persistent need to slash prices can be bad for businesses and could ultimately lead to layoffs, reduced consumer spending, and declining prices for a broad swath of assets, from real estate to commodities. Those forces, in turn, could put pressure on corporate profits and stock prices.

Inflation is a force to be reckoned with, too. But it’s deflation that really makes economists shudder.

What You Can Do
As regular readers know, I’m not a big fan of going overboard in anticipation of one specific economic scenario or another. For such a bet to pan out, you’d need to get your arms around myriad difficult-to-predict factors, including growth rates not just in the United States but overseas, as well.

If you’re truly concerned about deflation, you can take comfort in knowing that the investments that will tend to perform best in a declining-price environment are probably already in your portfolio. The classic deflation hedge is a simple fixed-rate investment–cash or government-issued bonds. (Corporate bonds will tend to be more vulnerable in a deflationary period because charging lower prices will tend to cut into the profitability–and viability–of many companies.) Because their payouts are fixed, the dough you receive via income from such vehicles is effectively worth more and more each year as prices fall. For the same reason, fixed annuities are also attractive in such an environment.

And while bonds will typically hold up better than stocks in a period of declining prices, the same “bird in the hand” logic means that dividend-paying stocks should hold up better than non-dividend-payers in a period of declining prices.

Go Easy
Although these investments are mainstays for investor portfolios regardless of the economic environment, it’s a mistake to go full-throttle into deflation-protection mode. That’s because the to-avoid/downplay list for deflationary times is a pretty long one, encompassing equally important investments such as most stocks, corporate bonds, commodities, real estate, and inflation-protected bonds.

And over the long haul, it’s also worth noting that inflation has been a bigger issue in the U.S. than has deflation. So hedging your portfolio against the former threat, particularly if you’re retired and relying on fixed-rate investments for much of your day-to-day income, is a better bet than getting too fancy about defending your portfolio against deflation.

Finally, bear in mind that the usual prescription for a deflationary period–government bonds and cash–isn’t currently offering much in the way of yield today. Cash investors are lucky to earn 1% on their money, whereas investors in intermediate- or long-term government bonds would be grateful to pick up 3% or 4%. Those yields would shrivel to next to nothing if inflation were to pick up. For all those reasons, positioning your portfolio for deflation alone is much more risky than it might seem.

A version of this article appeared on Morningstar.com on Sept. 14, 2010.

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