Deflation is when general prices for goods and services decrease. In other words, deflation is when the inflation rate falls below zero to a negative number. These time periods are rare and have a high correlation with a period of economic depression or severe recessions.

For an asset allocation guide of other inflation scenarios we also look at:

• ·        Guide to Investing During Increasing Inflation
• ·        Guide to Investing During Disinflation 

Investing During Deflation

Although deflation takes place only a fraction of the time compared to inflation, it is a critical period of time. Deflation destroys wealth and is the most difficult time period for investing. Time periods of falling prices offer the least amount of profitable asset allocation choices and therefore make choices during this trend more important than any other. It only takes one time of losing a majority of your wealth to guarantee falling short of your long-term investing goals.

Deflation can be caused by restrictive monetary policies, deleveraging of debt and restrictive credit, or conditions where supply outstrips demand. In reality a combination of these factors usually combine with other unknown factors to cause prices to fall.

Investors who recognize a period of deflation before it happens can make asset allocation choices that minimize the harm or even profit from falling prices. The following is a general asset allocation guide for a deflationary environment. Always check with your financial advisor to be sure an investment is right for your individual situation.

Deflation Guide

Large-Cap Stocks –  Avoid or Short.

Small-Cap Stocks – Avoid or Short.

Foreign Stocks – Avoid

Corporate Bonds – Avoid all except companies with the absolute strongest balance sheets.

Treasury  and other High Quality Bonds – Overweight because of perceived safety and possible capital gains as interest rates fall.

Treasury Bills – Overweight because of safety and increased buying power as prices of goods and services fall.

Inflation Indexed Bonds – Avoid. Many Inflation Indexed Bonds also index to negative inflation.

Commodities – Avoid.

Gold & Silver – Minimal or Avoid.  The only caveat here is if deflation threatens the soundness of the safest investments such as treasury bills; then people may flee to gold.

Real Estate – Avoid.  One of the worst investments in periods of deflation. This also makes it one of the best opportunities at the bottom of the deflationary cycle.

Summary

Deflation is the most destructive and dangerous of the inflation trends. Investors should take special care to recognize and make the appropriate asset allocation adjustments before deflation takes hold and destroys wealth. Your chances of meeting your investment goals will greatly increase if you can adapt your asset allocation to the current inflation cycle. Investing during deflation requires an asset allocation guide that pays special attention to capital preservation.