Understanding Inflation Vs Deflation

If you’ve spent time reading financial headlines over the years, odds are you’ve come across a few stories about the somewhat mystical phenomenon known as inflation. Inflation tends to be associated with bad economic omens, even if that’s not always as true for investors as it might be for the average consumer.

Less popular (but still as important) is the concept of deflation which, as you’d probably expect, is the opposite of inflation. Deflation gets less attention and is less common than inflation—but it has a massive impact on every sector of the economy nevertheless.

The effects of inflation and deflation depend largely on the composition of your portfolio. Both have positive and negative effects depending on a host of factors including your asset allocation, diversification, and overall approach to investing.

In this article we'll through the difference between inflation and deflation, how both impact your finances, what you can do to change your investing strategy when either are on the horizon, and how you can help buttress your portfolio against both of them.

What is Inflation?

Inflation is one of the more common (yet least understood) financial phenomena around. You’re likely to hear about how inflation makes the cost of goods increase, which is one of the largest impacts it has on the economy. But the causes and effects of inflation go far beyond making a gallon of milk cost more at the grocery store.

Generally speaking, inflation means that a currency’s value is decreasing. This results in less purchasing power: what could once be purchased with a dollar may now cost two. Why inflation happens is a bit more complicated though. Generally speaking, inflation can be the result of too much money in a country’s economy if the rate of inflation is high. If inflation increases slowly, it is typically viewed as a sign of a country’s economic health.

In the United States, the Federal Reserve releases money into the general economy and sets baseline interest rates. When interest rates are low, the economy is said to have a surplus of money flowing through the system. This lowers the value of a dollar as a result, which in turn makes goods more expensive. Consumer confidence typically dips during inflationary periods, which makes the average person less willing to spend money.

For the last 10 years, inflation has stayed relatively manageable at anywhere from 0 to 2.5 percent. This modest increase in inflation has been enough to provide a robust economy without too much capital being injected into the system. The COVID-19 pandemic’s effects on the economy may change this, however—how and when is still yet to be determined for the near term.

How Does Inflation Affect My Portfolio?

The ways in which inflation might affect your portfolio generally depend on what kind of assets you own, as well as the pace of inflation itself. Slow increases in inflation don’t typically affect markets in an adverse manner.

If you’re heavy on stocks and mutual funds, you may end up suffering from less consumer confidence in the economy. People aren’t as willing to open their wallets when a dollar doesn’t go as far as it used to, which can create a drag on stock prices for businesses that sell goods and services to consumers.

Additionally, if you own stocks that rely on raw materials for manufacturing, you may also find that these businesses have lower margins when inflation occurs. If raw materials cost more to buy, many businesses’ margins will suffer as a result. Smaller margins means less income, which in turn means missed financial projections and lower stock prices in many cases.

If you’ve incorporated alternative investments into your portfolio, however, inflation may end up having a positive effect. Commodities in particular tend to see an increase in value because of inflation. This is because the cost of essential goods—corn, wheat, and gold—increase. This means the value of your investments rises as well. This also extends to other alternatives, like farmland, which we’ll cover later on.

What is Deflation?

Deflation is—you guessed it—the opposite of inflation. When deflation occurs, there’s less money circulating in the economy and interest rates are often higher. The value of a buck increases, and the value of goods decreases. This additional purchasing power can embolden consumers to spend more money, even if businesses suffer as a result of selling their goods for what amounts to lower prices.

Deflation can also impact the ways in which businesses borrow money. Higher interest rates mean that the credit market is shrinking, and each loan ends up costing more in terms of interest payments. Thus, businesses are less inclined to borrow money, which may have a drag on financial markets as the free flow of cash slows to a trickle.

Current financial conditions indicate that deflation may be on the rise as consumer prices drop marginally. Given the unprecedented economic impact of the pandemic, it’s hard to tell whether or not deflation will predominate, however.

How Does Deflation Affect My Portfolio?

Much like inflation, deflation affects your portfolio in different ways depending on what you own, and the markets in which you have exposure. If your investments skew heavily toward financial services, for example, you may find that higher interest rates end up dragging down investment banks’ ability to access inexpensive loans. This in turn can end up decreasing their value and stock price, since cheap cash helps make financial deals happen more easily.

Deflation may also signal a weakening economy due to lower consumer demand for goods. If fewer people want to buy things, the price of most goods drops as a result. Conventional economic theory holds that consumer reluctance to spend correlates to financial worries for families, which in turn means an economy may be on the brink of a recession. This isn’t always the case, however. Some countries that have experienced a short deflationary period saw little to no ill effects on their general economic health.

What Kind of Investments Diversification Can Hedge Against Inflation?

There are ways for investors to hedge against both inflation and deflation—both of which typically manifest themselves as opposing kinds of investments. Common hedges against inflation consist of foreign bonds, commodities, and other assets that either retain their value in spite of economic volatility or offer a guaranteed return.

Each of these options come with their own advantages: gold as a commodity retains its value well historically speaking, and agricultural commodities tend to increase in value as the price of these goods increases as well. Foreign bonds based in countries where inflation is not happening as quickly may help you get the most bang for your investment buck. On the other hand, each option also comes with unique downsides: gold can be prohibitively expensive (and offer little opportunity for a return on investment), grain prices still fluctuate in an inflationary economy, and foreign bonds might stumble if inflation becomes a global phenomenon.

This is where farmland investing shines as a hedge against inflation. Historically speaking, farmland has retained its value remarkably well in a variety of economic environments—even increasing in value when other investment types do not. Plus, farmland investing provides exposure to increasing commodity prices, as you’re entitled to a share of the profits from crops sold.

What Kind of Investments Can Hedge Against Deflation?

Safeguarding your portfolio from deflation means adopting an entirely different investment approach than you would for inflation, in most cases. Common consensus says that hedging against deflation means allocation your portfolio to be heavier on bonds (which retain value and a guaranteed interest rate payout), shares of consumer goods companies, and stocks that offer dividends on a regular basis.

Each of these investment options offer different kinds of hedges against deflation: bonds lock in a set payment you’ll receive at the end of the bond’s term, which means you’ll end up with a return that’s worth more in the long-run. Consumer goods companies may see a boon in activity if consumer purchasing power increases and people are more willing to spend money. Dividend-paying stocks can also pay out on your investment more regularly, which also provides you with tangible assets that you can either reinvest or turn into cash. Speaking of cash—keeping investments liquid can also be a good hedge against deflation, as you may find that the cash value of your holdings is higher than what you might get through stocks.

Farmland investing can also serve as a great hedge against deflation. Since the value of farmland real estate is historically steady, there’s less risk that your investment will lose value irrespective of inflationary or deflationary activity. Plus, any increase in consumer activity that impacts agricultural commodities can potentially lead to increased sales for farms—so long as the price of grain and corn doesn’t fall sharply as part of the deflationary period.

The Bottom Line on Inflation vs. Deflation

Both inflation and deflation can be a boon (or a blow) to your portfolio. As with all kinds of investing, the effects of either depend on how you’ve set up your investments and how equipped you are to minimize exposure to the downside of these and other market conditions. Since inflation and deflation have different results depending on the economic sector, investment type, and your own diversification, it’s worth considering how well prepared you are if either are on the financial horizon.

One of the best ways to hedge against inflation is by investing in alternatives that give you exposure to commodities and other household staples. This makes farmland investing particularly suited to offset downturns in commercial sectors when inflation makes consumers less willing to spend. When deflation occurs, and consumer goods become less expensive, farmland investing gives you the security of a historically stable real estate play—covering you when either trends prevail in the markets.