What's So Bad About Deflation?

When prices rise, purchasing power falls, the value of our investments shrinks, and inflation rears its ugly head. You might think that deflation would thus be welcome: prices fall, purchasing power rises, and our investments grow, right? What's not to love?

Plenty. For starters, if prices fall, so will many companies' revenue, which could ultimately prompt layoffs and stagnant or declining wages.

Falling demand for goods and services can also trigger deflation, as companies lower prices to attract more sales. That can become a vicious circle, with buyers holding out for still-lower prices while the value of their cash rises. (It's not hard to imagine homebuyers waiting for better prices in a falling-price environment.) Oversupply can also trigger price-cutting, fueling deflation.

How to fight the dreaded d-word
To get a handle on how you might invest in a deflationary environment, think about the defensive and not-so-defensive companies that get discussed in relation to economic downturns. When the economy is in a slump, consumers often put off or avoid big-ticket or luxury purchases. However, they can't avoid buying staples, and they'll still go for inexpensive treats. Thus, Ford and Joe's Jeans tend to suffer more, because people aren't in any hurry to pay thousands for a new car or $100 and up for a pair of jeans. Meanwhile, companies that produce things that people have to have can hold up better in deflation.

Investors worried about deflation might also want to look to companies that reliably generate a lot of cash, since that cash will gain value over time. Many such companies are good dividend payers, lacking better uses for those dollars. These outfits fit the bill:

Data: Yahoo! Finance.

Altria's consumers are mostly committed to buying its tobacco offerings, making it rather defensive (even though America's overall smoking rate is slowly declining). People don't cut back on their energy use too drastically in market downturns, propping up Exelon's business. And when there are medications or sundries to buy, people do so without much regard for the economy.

Opinions are mixed about whether deflation will hammer us anytime soon. (Yes it will! No it won't!) In that light, looking at companies like the ones above makes even more sense, since they can provide multiple defenses against deflation or inflation.

You're right to fear deflation, but you're not powerless to stop it. Carefully choosing the right investments can protect your portfolio's weak spots, and help you fight back.

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