Cents and Sensibility
Cents and Sensibility
What do deflation
and inflation
mean to investors?Question: I have my money in a bank here in Hawaii earning less than 1 percent. I'm worried about inflation eating away at my savings. Are there other options I should be considering?
Answer: During the course of our lives, we've become accustomed to inflation -- a constant trend of rising prices. During some periods, such as the late 1970s, inflation was strong. But for the last several years, inflation has been mild.
Now, however, some -- but not all -- economists think we may be entering a period of deflation, in which supply outstrips demand, causing prices to fall. As an investor, what would this mean to you? Or should the economic environment make any difference in your investment strategy?
There's no single answer. But keep in mind that things can change. In 2003, inflation is low enough to make people start thinking about deflation. And yet, you're not investing for just this year -- you're investing to achieve goals that are 10, 15, or 20 years down the road.
During the intervening years, the inflation/deflation situation could change markedly. Nonetheless, you'll want to at least consider the effects of inflation or deflation on potential investments -- so keep a few things in mind:
>> Only stocks have significantly outpaced inflation. In looking back over the 75 years from 1926 through 2001, you'll find that stocks were the only financial asset to keep investors significantly ahead of inflation. When inflation is factored in, common stocks brought an annual average return of 7.73 percent, compared to 2.18 percent for long-term government bonds and just 0.71 percent for Treasury bills, according to the investment research firm Ibbotson Associates.Yet, you certainly don't want to overreact by selling off a large percentage of your stocks. Instead, strive to build a diversified portfolio containing stocks and bonds -- as well as government securities, CDs and money market accounts.While the past performance of all these investments is no guarantee of future results, history suggests that you'll need some exposure to stocks if you're going to preserve your purchasing power.
>> Cash becomes more valuable during deflationary times. When prices are rising, you can borrow with the knowledge that you'll be paying off your debt in tomorrow's cheaper dollars. On the other hand if prices are falling, you're better off delaying purchases rather than buying on credit.
Quite simply, as prices drop, cash becomes more valuable. So, if inflation remains low, or if we enter a truly deflationary period, your money market accounts take on more value than they would in times of inflation. Keep in mind, though, that you won't want your portfolio to become overly "cash heavy." You'll still need growth to achieve your financial goals -- so, once again, you need to own stocks.
>> Deflation may affect stocks and bonds differently. If inflation declines significantly, or becomes deflation, interest rates will fall -- which means bond prices will rise. Conversely, falling prices of goods and services typically translate into falling profits for businesses -- and that's obviously not good for stock prices.
When you invest, don't forget about the effects of inflation or deflation -- but don't get hung up on them, either.
The tried-and-true keys to investment success -- diversification, quality and value will hold up if prices are going up, down or staying the same.
Guy Steele is a financial planner and head
of the Pali Palms office of Edward Jones. Send
planning and investing questions to him at 970
N. Kalaheo Ave., Suite C-210, Kailua, HI, 96734,
or by email at: gsteele2@pixi.com