How to Prepare for Deflation

The Federal Reserve is injecting large sums of liquidity into the system in the hopes of preventing deflation—which, to most economists, is more to be feared than inflation. During a deflationary period, the value of all asset classes declines, leaving no safe haven except cash, which reduces the total investment in the economy and creates a dangerous negative feedback loop.

Although we may be headed for inflation in response to the Fed’s actions, if we look at the price of oil, stocks, cryptocurrencies, and certain bonds all tumbling around the same time, we may be entering into a period of deflation instead. What can you do to prepare for deflation? First and foremost:

Keep cash on hand. Today’s puny interest rates on money market and checking accounts are a big turnoff. But with deflation the calculation changes, since even a zero percent interest rate isn’t so bad. If real assets are falling in value by 2 or 3 percent per year, then cash is actually appreciating in value compared with other things. Upping your cash cushion also helps prepare for emergencies—or investing opportunities, if they suddenly appear.”

Another thing to keep in mind when you watch falling stocks and consumer prices is that they can fall further still:

Resist the lure of falling prices… Be wary of stocks. Stocks go through short-term spurts for all manner of reasons, but on the whole they go up or down in tandem with economic growth. Deflation usually accompanies a recession or slow growth, which suggests that the stock market will be subdued if deflation predictions are correct.”

Although bonds are not a sure bet during a period of deflation, often the low return of bonds is just enough make everyone rush into it and drive up the value.

Double down on bonds. With interest rates historically low, many investors find the weak return on high-quality bonds and Treasury securities unappealing. But if deflation occurs, a low return suddenly looks pretty good because it protects principal and offers a bit of appreciation.”

Historically, real assets such as houses and gold do poorly during deflation, though not quite as poorly as stocks. It is still a good idea to have these assets in your portfolio, but don’t put all your eggs in one basket. This is not the time to be flipping houses and spending all your cash on gold bars. Also, prepare yourself mentally to watch your home fall in value, but remember that you have to live somewhere.

Eventually, deflation will come to an end, and a diversified portfolio will pull through this period, but it is a good idea to keep the specter of deflation in mind when preparing your investment portfolio, especially during these difficult times.

Quantitative Easing

The Federal Reserve is injecting large sums of liquidity into the system in the hopes of preventing deflation—which, to most economists, is more to be feared than inflation. During a deflationary period, the value of all asset classes declines, leaving no safe haven except cash, which reduces the total investment in the economy and creates a dangerous negative feedback loop.

Although we may be headed for inflation in response to the Fed’s actions, if we look at the price of oil, stocks, cryptocurrencies, and certain bonds all tumbling around the same time, we may be entering into a period of deflation instead. What can you do to prepare for deflation? First and foremost:

Keep cash on hand. Today’s puny interest rates on money market and checking accounts are a big turnoff. But with deflation the calculation changes, since even a zero percent interest rate isn’t so bad. If real assets are falling in value by 2 or 3 percent per year, then cash is actually appreciating in value compared with other things. Upping your cash cushion also helps prepare for emergencies—or investing opportunities, if they suddenly appear.”

Another thing to keep in mind when you watch falling stocks and consumer prices is that they can fall further still:

Resist the lure of falling prices… Be wary of stocks. Stocks go through short-term spurts for all manner of reasons, but on the whole, they go up or down in tandem with economic growth. Deflation usually accompanies a recession or slow growth, which suggests that the stock market will be subdued if deflation predictions are correct.”

Although bonds are not a sure bet during a period of deflation, often the low return of bonds is just enough to make everyone rush into it and drive up the value.

Double down on bonds. With interest rates historically low, many investors find the weak return on high-quality bonds and Treasury securities unappealing. But if deflation occurs, a low return suddenly looks pretty good because it protects principal and offers a bit of appreciation.”

Historically, real assets such as houses and gold do poorly during deflation, though not quite as poorly as stocks. It is still a good idea to have these assets in your portfolio, but don’t put all your eggs in one basket. This is not the time to be flipping houses and spending all your cash on gold bars. Also, prepare yourself mentally to watch your home fall in value, but remember that you have to live somewhere.

Eventually, deflation will come to an end, and a diversified portfolio will pull through this period, but it is a good idea to keep the specter of deflation in mind when preparing your investment portfolio, especially during these difficult times.

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