Inflation and deflation are economic factors that investors must consider when planning and managing their portfolio. The two trends are opposite sides of the same coin: Inflation is defined as the rate at which prices of goods and services increase; deflation is a measure of a general decline in the prices of goods and services. Regardless of the current trend, the steps investors can take to protect their assets are clear, although the economy can shift quickly from one to the other, making it more difficult to determine the appropriate steps.

What to expect during inflation

Over time, prices tend to increase, whether it’s a loaf of bread, a haircut, or a house. When these increases become excessive, consumers and investors may face difficulties because their purchasing power will fall quickly. A dollar (or whatever currency you deal with) buys less; this means it is inherently worth less.

A clear example of surging inflation occurred in the United States in the 1970s. The decade began with inflation hovering around 10%. In 1974, this figure exceeded 11%. After a decline, it rose to more than 11% in 1979, peaking at around 13.5% in 1980. With investors getting stock returns in the mid-single digit range and inflation running at double that figure, making money in the market was a difficult task.

Protecting your portfolio from inflation

There are several popular strategies for protect your wallet the ravages of inflation.

It is first and foremost the sotck exchange. Aside from the “stagflation” of the 1970s, rising prices tend to be good news for stocks. Growth stocks grow alongside an inflationary economy.

For fixed income investors looking for an income stream that keeps pace with rising prices, Treasury Inflation Protected Securities (TIPS) are a common choice. These government-issued bonds come with a guarantee that their face value will increase with inflation, as measured by the Consumer Price Indexwhile their interest rate will remain fixed. Interest on TIPS is paid semi-annually. These bonds can be purchased directly from the government through the Trésor Direct system in increments of $100 with a minimum investment of $100 and are available with maturities of five, 10 and 30 years.

International bonds also offer a way to generate income. They also offer diversification, giving investors access to countries that may not experience inflation.

Gold is another hedge against inflationbecause it tends to retain or increase its value during inflationary periods. Other commodities can also fall into this category, as can real estate, as these investments tend to increase in value when inflation rises. On the raw materials side, emerging countries often generate significant revenues from their raw materials exports. Adding stocks from these countries to your portfolio is therefore another way to play the commodities card.

What to expect during deflation

Deflation is a less common phenomenon than inflation. This may reflect a glut of goods or services in the market. It also occurs when a drop in demand in the economy causes prices to fall excessively: periods of high unemployment and economic depression often coincide with deflation.

from Japan lost decade (the period between 1991 and 2001) highlights the ravages of deflation. The era began with the collapse of the stock market and the real estate market. This economic collapse led to a reduction in wages. Lower wages led to lower demand, which led to lower prices. The drop in prices raised concerns that prices would continue to fall, so consumers were reluctant to make purchases. The lack of demand caused prices to fall further and the downward spiral continued. Combine that with near-zero interest rates, a depreciating yen, and a screeching halt to economic expansion.

Protecting your portfolio from deflation

When deflation poses a threat, investors adopt a defensive attitude by favoring bonds. High-quality bonds tend to fare better than stocks in times of deflation, which bodes well for the popularity of government-issued debt and AAA-rated corporate bonds.

On the stock side, companies that produce consumer goods that people have to buy no matter what (think toilet paper, food, medicine) tend to hold up better than other companies. These are often called defensive actions. Dividend-paying stocks are another consideration in the stock space.

Cash is also becoming a more popular investment security. In addition to the good old savings accounts and interest-bearing checking accounts, there are also cash equivalents: Certificates of Deposit (CD) and money market accounts, highly liquid assets.

Plan for inflation and deflation

It is sometimes difficult to tell whether inflation or deflation poses the greater threat. When you don’t know what to do, plan for both. A diversified portfolio this includes investments that thrive during inflationary periods and investments that thrive during deflationary periods can provide a measure of protection, regardless of what is happening in the economy.

Diversification is key when you don’t feel like trying to time the inflation/deflation cycle correctly. Blue-chip companies tend to have the strength to resist deflation and pay dividends, which is helpful when inflation rises to the point where evaluations stagnate.

Diversification abroad is another strategy, such as emerging markets are often exporters of highly demanded raw materials (protection against inflation) and are not perfectly linked to the national economy (protection against deflation). The aforementioned high-quality bonds and TIPS are reasonable choices on the fixed income side. With TIPS, you are guaranteed to recover at least the value of your initial investment.

The time horizon also plays an important role. If you have 20 years to invest, you will likely have time to weather a downturn of any kind. If you are close to retirement or living off your portfolio income, you may not be able to wait for a recovery and will have no choice but to take immediate action to adjust your wallet.