Economic Deflation Definition and How to Invest

Understanding the Economics of Investing Can Make You a Better Investor

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The simple definition of deflation is that it is when an economy experiences declining prices for goods and services. In this regard, deflation is the opposite of inflation, where the cost of goods and services is rising. Understanding the economics of deflation can make you a better investor.

You may have already heard or seen this economic term. But what does it mean and how does it relate to investing? Are there certain investment types that do best during deflation? How do deflationary periods compare to inflationary periods?

Here are the basics of deflation and what investors need to know when prices are falling.

Definition of Economic Deflation

Deflation is an economic term that describes an environment of declining prices for goods and services within an economy. Not to be confused with disinflation (a decrease in the rate of inflation), deflation can also be called negative inflation because it occurs when the rate of inflation is less than 0%.

Deflation can occur in recessions, where demand for most goods and services declines and the providers of these goods and services lower prices to compete for fewer consumer dollars. In extreme cases, consumers delay purchases in anticipation of further price declines. This can often lead to a self-fulfilling prophecy of lower prices, where consumers expect lower prices and create them by foregoing purchases.

The Great Depression is an example of the result of out-of-control deflation.

A recent example of deflation occurred during "The Great Recession" of 2007-2008, where the inflation rate fell below 0%. Taken out of context, this might sound like a good thing for consumers, but lower prices are a reflection of lower demand, which arises because lower demand becomes lower revenues, which leads to layoffs and less income for consumers. 

Deflation Investment and Hedge Strategies

Investing during economic deflation can be challenging—asset prices are falling, causing a loss of interest and value in cash, gold, real estate, and stocks. While these assets generally pay off in an inflationary environment, during a deflationary period they tend to create losses.

Better investments when prices are falling include bond funds, especially long-term bonds because interest rates are falling (and bond prices may, therefore, be increasing).

Certain sector funds that invest in defensive areas, such as health care, utilities, staple items, and certain commodities—things people need regardless of economic conditions—can also be good investments during deflationary periods. For example, people still need to go to the doctor, use electricity, and brush their teeth when the economy and stock market are on the downside. This demand generally prevents stocks in these sectors from declining as much as the broader market.

The Federal Reserve exercises monetary policy that works to prevent a deflationary spiral and tries to keep the period from lasting for an extended period of time. Therefore, investments that do well when interest rates are falling can do well during periods of deflation.

The best investment types during deflationary periods include long-term bond funds, zero-coupon bond funds and sometimes dividend stock funds. Investment types that may not work in deflationary periods, with some extreme exceptions, include precious metals funds, money market funds, or investments that depend upon higher prices and interest rates.

Tips and Cautions for Investing

There is a risky market timing element when trying to choose the best investments during an expected short-term deflationary environment. Trying to navigate the market and economic conditions with investment strategies is a form of market timing that carries a significant risk of losing value in an investment account. For most investors, building a diversified portfolio of mutual funds is the best strategy for all market and economic environments.