The current state of the economy has even well-known businessmen and financial experts shaking their heads with uncertainty. But regardless of what happens next in one of the most difficult periods investors have ever faced, you can ensure that your portfolio has investments that will help you protect your wealth and let it grow.
Where are prices going?
One of the toughest calls people are trying to make is what will happen with price levels in the future. Falling home prices in recent years, accompanied by the bursting of the commodities bubble last summer, threatened to throw the economy into a deflationary spiral last year. Some still believe that deflation may be the biggest concern going forward unless the economy starts to grow again.
On the other hand, others point to all the efforts from Congress and the Federal Reserve to jump-start the economy as potentially highly inflationary. With trillions of dollars in stimulus and other means of capital injected into the economy just in the past 12 months or so, the liquidity is in place for inflation to rise should the pace of economic activity start to increase.
On balance, it's extremely tough to make a call on which camp is correct. Both sides make valid points, and we'll likely just have to wait and see in order to figure out whose argument proves to be the correct one.
Why it matters
The problem, though, is that you need to know how to invest now. The investment decisions you'd make if you anticipate deflation are far different from the investments you'd choose to protect yourself against future inflation.
Specifically, to get inflation protection, you might:
- Load up on commodities and commodity-related stocks like BP
(NYSE:BP), Mosaic (NYSE:MOS), and Freeport-McMoRan (NYSE:FCX).
- Reduce cash and bond holdings in your portfolio instead of buying stocks of companies that can pass their higher costs of supplies and raw materials on to customers.
- Opt to include the necessary fixed-income exposure in your portfolio by buying inflation-indexed bonds, which would help you avoid the loss of purchasing power that most traditional bonds and CDs would suffer.
- Invest abroad in other economies that might not face as much inflationary pressure, such as Japan.
On the other hand, in a deflationary environment, you'd draw much different conclusions:
- Cash and bonds do extremely well during deflationary times, so above-average allocations would serve you well.
- You'd likely avoid, however, companies that depend on stable asset values. A sustained deflationary period would further hamper bank loan portfolios, for instance, making stocks like Wells Fargo
(NYSE:WFC), Bank of America (NYSE:BAC), and US Bancorp (NYSE:USB)ill-advised investments.
- On the other hand, certain stocks that would benefit more from lower raw materials costs without losing pricing pressure could see substantial gains. For instance, a company like Coca-Cola
(NYSE:KO), which relies on its brand presence to command premium prices for its products, might be able to sustain its pricing while reaping gains from obtaining its ingredients more cheaply.
Splitting the difference
Obviously, taking a chance and investing all your money based on one of these scenarios gives you the best chance to score strong future gains. If you make the right choice, you'll be positioned perfectly. If you guess wrong, though, you could put yourself in a position from which you'll never fully recover.
So, if you can't afford to be completely wrong, then the safer strategy is to hedge your bets by holding a diversified portfolio that includes some favored investments for both scenarios. Hold a fair share of stocks, bonds, and cash, with mixed exposure to both inflation-resistant and deflation-resistant industries in the stock market.
Sure, you'll give up some of your returns this way. But you'll be better protected for whatever may come in the future. Given how bumpy the markets have been lately, that protection might be the last step in giving you the financial security you need.
For more on becoming financially independent, read about:
- You can't really count on Social Security to save you.
- These stocks aren't waiting for the recovery.
- Are you costing yourself 42%?
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Fool contributor Dan Caplinger always likes to hedge his bets. He owns shares of Freeport-McMoRan. Coca-Cola is a Motley Fool Inside Value selection and an Income Investor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is a sure thing.