Investment Strategy Needs to Factor Inflation ... and Deflation

,

Both inflation and deflation are serious potential risks to your investment portfolio. Nonetheless, few physicians adequately understand these risks and properly hedge against them. For a variety of reasons, these risks may become even more pronounced.

Both inflation and deflation are serious potential risks to your investment portfolio. Nonetheless, few physicians adequately understand these risks and properly hedge against them. For a variety of reasons, these risks may become even more pronounced.

What is inflation?I

n economics, inflation is defined as a rise in the general level of prices of goods and services in an economy over a period of time. Inflation is the idea that a dollar buys less today than it did at some period in the past. This is the normal trend over time and the average U.S. inflation rate over the last 70 years or so has been approximately 3%.

Deflation is correlated with

Deflation is the relative decrease in costs of goods and services in an economy over a period of time. This means you can buy more with the same dollars. Currently, economists generally believe that deflation is a problem in a modern economy.

, including the

.

recessionsGreat Depression

What is deflation?

As an investor, you could be living in a time when the economy is subject to inflationary forces, but certain investment classes face deflationary influences. This creates an opportunity we will discuss later in the article. Before we get to our suggestions, let’s explore a few arguments.

Both sides of the inflation vs. deflation debate can make a strong case. As a people, we have a huge amount of spare investment capacity in the economy caused by the collapse in demand.

Inflation vs. Deflation

High unemployment, low levels of consumer confidence and increased scepticism with investment advisory firms (see Goldman Sachs congressional hearings, Madoff, Stanford, etc.) are all factors in consumer reluctance (or inability) to make investments. When less money is available for investment, the result is declining prices of those investments. These factors support the argument that we are in a deflationary period.

Despite the macro-economic factors that are pushing the economy in one way, the banking industry has the ability to make changes that can impact the economy and its direction. The central banks appear determined to forestall deflation through an increase in the supply of money and a decrease in the cost to borrow that money. Interest rates are at record lows.

When it is easy or cheap to get your hands on money, it is referred to as “loose” monetary conditions. Loose conditions make it easier for people and companies to buy things (with other people’s money they have borrowed). The more buyers there are, the more natural it is to experience inflation. More money = more buyers. More buyers = higher prices of goods.

Despite the best efforts of the banking industry, stagnant home prices and unemployment near 9% have made deflation much harder to shake than many would have guessed. Optimists believe that rock bottom interest rates and massive stimulus programs will eventually cause inflation to pick up speed at some point.

We believe that short-term deflation will be followed by long-term inflation. However, predicting when the pendulum will swing in the other direction is a guess at best. What you must realize is that in periods of deflation (recession) or inflation, the risk inherent within each asset class is magnified. Recessionary forces create certain challenges and often lead to consolidation within each industry. Inflation can have a similar impact, as many companies will struggle with increased costs of labor, raw goods and financing.

In short, you can expect the best-run companies to capture significant market share as the economy swings from deflation to inflation. Many poorly run firms will ultimately fail. The impending economic changes are likely to reward investors who make the best choices within each asset class

be it equities, bonds or hard assets

How to make informed decisions with your portfolioover passive investors who choose more general index-based investing that follows the market as a whole.

If you are putting all your money in cash to avoid risk, and inflation is the outcome, you will lose significant buying power with that cash. In other words, if everything increases in cost by 7% (inflation) and your money in the bank grew by 2%, you would lose 5% of the buying power of your cash.

Think of the end of the “dot com” era. Amazon, eBay and a number of other firms flourished while hundreds of others failed. Good advice and valuable research will be very important. The cost of waiting to invest

Gold, oil and natural gas

all purchased through the use of individual stocks and/or exchange-traded funds

could be welcomed additions to your portfolio in the face of uncertain inflation or deflation.

Alternative investments may hold the key

Foreign currencies (exchange-traded funds and structured notes) are also an option for a bearish dollar trade in your investment account. Many of our clients have been exploring and investing in these investment classes as a hedge against inflation and movement of the value of the dollar against other currencies.

Other popular investment strategies include programs that are not traded on a public exchange like the New York Stock Exchange. Non-traded real estate investment trusts, leasing funds, and oil and gas drilling programs are a few examples. Given recent market conditions, many investors have been attracted to non-traded programs because they offer a certain level of stability.

Inflation is likely to punish anyone — and any company — that is not in good financial shape. One of the biggest problems that inflation causes is uncertainty. Commodity markets are currently priced assuming future "hyperinflation," while the prices on bond markets predict little or no inflation. One of them has to give, but we won’t be able to tell who the winners and losers are for years to come.

Avoid devastating mistakes

Dinah Bird, PhD, CFP, CIMA, is the director of Institutional Development and Portfolio Management at the OJM Group. Kim Renners, MBA, CPA (inactive), is the director of Wealth Management at the OJM Group and can be reached at

. For a free (plus $5 S&H) copy of

Inflation deals a wild card, making it much harder to anticipate the direction of the economy and the markets. Make changes to your portfolio now so you will be better prepared for the volatility ahead. kim@ojmgroup.comFor Doctors Only: A Guide to Working Less and Building More, please call (877) 656-4362.

Disclosure: This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the financial markets involves the potential for gains and the risk of losses and may not be suitable for all investors. Alternative investments may carry additional risks including a lack of liquidity which may make it difficult to sell off an investment after it is made. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. For additional information about the OJM Group, including fees and services, send for our disclosure statement as set forth on Form ADV using the contact information herein. Please read the disclosure statement carefully before you invest or send money.