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| Dealing with Deflation |
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Most investors have been well-schooled in how to counter the impact of rising inflation on their retirement portfolios. Inflation is what slowly erodes the value of your savings over time. It's the reason your Dad only paid $0.69 for a six-pack of Coke in 1972 and you are paying $3.99 for that same product today.
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But what about deflation? The reality is that although experienced investors may adjust their strategies to counter deflation, your best bet is to continue putting your retirement savings into a well-diversified portfolio during a deflationary period.
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Basically, deflation occurs when the annual inflation rates dips below zero. As a result, the prices of goods and services plummet and the real value of your money increases. Deflation means you can buy more with less.
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Understanding Deflation
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At first blush, that would seem like a good thing, right? Wrong. When deflation hits, consumers stop spending in anticipation that prices will continue to drop. Meanwhile, companies are less profitable because their goods and services are worth less and because consumer demand has cooled. To maintain a profit, companies have to cut costs and headcount. As a result, wages decline and the ranks of the unemployed grow. Housing prices also tend to plummet during deflationary periods, leading to increased foreclosures and underwater mortgages. Deflation also makes it much more expensive to pay off debts.
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Deflating Investments
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Meanwhile, deflation can quickly transform the investment landscape. For instance, stocks often become less attractive as companies' profits decrease. The stocks that tend to retain some of their luster are usually large-cap, high-quality companies with little debt. Inflation-indexed bonds, non-dividend-paying stocks, and anything tied to a real asset such as gold or real estate tend to do poorly in a deflationary environment. Meanwhile, long-term bonds (such as high-quality corporate bonds or municipal bonds) tend to be the investment of choice during deflationary periods as they pay a fixed rate of return.
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However, if your retirement portfolio is already well-diversified, then you probably shouldn't change it. Making tactical bets in anticipation of deflation or in response to deflation is usually not a good idea, especially for inexperienced investors. A diversified retirement portfolio is designed to help you weather different market and economic conditions, as well as to help you take advantage of market upswings when they occur.
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That said, there's one thing you can do to take the pain out of deflation—pay off your debts. During a deflationary period, a high debt load can be crippling as you have to pay back more than you originally owned in adjusted dollars. In other words, the cost of paying off your debts becomes higher.
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Although deflation is an alarming proposition as they tend to last a long time (Japan has been in the grips of deflation on and off for almost 20 years), thankfully it is a rare occurrence. The last time the US experienced a significant deflationary period was during the Great Depression.
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