How to Invest During Deflation

How to Invest During Deflation
••• Andrew Burton/Getty Images News/Getty Images

Deflation reflects a consistent decline in the prices of goods and services across the board in an economic market. During deflation, commodity prices and corporate profits tend to fall. It can take a long time to recognize a deflationary economy. Measures such as the Consumer Price Index and Producers Price Index should trend consistently downward for a period of several years before to the economy is described as genuinely deflationary. As an investor, you can position your portfolio to minimize risks associated with a prolonged deflation.

Reduce Exposure to Stocks

Stocks tend to perform poorly during deflationary periods, because falling prices for goods and services are reflected in corporate earnings. You can prepare for this by reducing your exposure to stocks in your investment portfolio. You can shift holdings within your stock investments to the stocks of companies that are subject to lower risks associated with deflation. Focus on stocks of companies with high cash balances and dividend payout ratios, but also companies situated in industries that are generally more stable, such as health care, agricultural and energy.

Find Short Exchange-Traded Funds

Inverse exchange-traded funds, or ETFs — also called short ETFs — generally work by inversely tracking various indexes, producing positive returns when the underlying index performs poorly. Use them to hedge deflation risk or to make an outright play against deflation. Inverse ETFs come in many forms, including inverse equity, fixed income and commodity funds. You can also invest in funds that were created as hedges for deflation by inversely tracking the CPI and volatility indexes.

Fixed Income Options

Bond performance is mixed during deflationary periods, with longer-term bonds outperforming short-term bonds. This is because deflation leads to a flight to quality, shifting funds to the perceived safety of Treasury securities. This causes yields to drop and prices to rise. Long-term bonds have higher durations than short-term bonds, which results in greater price appreciation. Duration is similar to maturity, except it factors in cash-flow-weighted returns by accounting for the timing of bond payments. It assigns more weighting to periods during which cash flows take place. Also, zero-coupon bonds perform well during deflation, because the yields are fixed and no coupon payments are made; the returns are earned from the return of appreciated principal.

Other Hedging Strategies

Gold can be a solid hedge against deflation, because the Federal Reserve Bank tends to fight deflation by taking inflationary measures, such as printing currency. Gold is a good hedge against these actions, because it is viewed as a safe investment during periods of crisis. It is highly liquid and valued globally, and its value is not dependent on the health of any financial backer. Likewise, you can increase cash holdings relative to other investments, especially any fixed assets, because deflation causes asset values to fall relative to cash values. Reduce your exposure to debtors and real estate investment companies. Debtors are affected by opportunity cost, having lent based on collateral assets that decrease in value.