How To Invest For Inflation & Deflation
Instability Requires That You Know How To Invest For Both Inflation & Deflation
Key Ideas
- Reveals why economic stability is a thing of the past.
- Learn why I believe inflation will ultimately prevail and what it means for investors.
- Discover which investment strategies you can use for success against inflation, or deflation.
The secret is out…
The stable economic past we grew up with is just that – the past. The future is going to look very different.
Some prognosticators are screaming inflation, while others are equally well-reasoned in their deflation forecasts.
My best guess is they will both be wrong – and both be right.
In other words, extreme volatility should be expected to continue as it has in the recent past, and that will wreak havoc with your investment strategy.
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Economic Forecasting Is Worthless
Before I dig into the investment strategy issues associated with that forecast, let me clarify an important point.
Long-time readers know I avoid economic forecasting like the plague.
3 decades of real-time investing experience has taught me that economic forecasts are worthless. They make soothsayers and goat entrail readers look like respectable professions.
Sure, some brilliant guys get it right on occasion, but a broken clock is right twice a day and you still can't tell time with it.
Similarly, you can't invest based on forecasts because eventually your forecast will be wrong, and you'll lose big-time. (Surprisingly, the time you are most likely to be wrong is when you are most confident that you are right. :-))
The truth is nobody really knows whether we'll have rocketing inflation or free-falling deflation over the next year or two (notice the time-frame, 1-2 years), despite confident forecasts.
Such clairvoyance requires a direct connection to a Higher Power or a magical crystal ball, both of which forecasters lack.
Yes, I agree the economics are unequivocally clear that the Fed's shenanigans virtually assure a serious inflation in the future (10+ years), but the exact sequencing of how that will occur is unknown.
I have no idea if it will start this year, 5 years from now, or 10 years from now. I just know it's baked in the cake.
The problem is, that's not good enough.
Extraordinary gains and losses can and will occur in the interim time periods of 1-4 years. Those gains and losses can make or break your financial success.
Every investment strategy is essentially a bet on a specific economic outcome (inflation or deflation, growth or decline, etc.). When the outcome is different from expectations, then you lose.
Unfortunately, about the only forecast I have any confidence making is that devastating periods of volatility will continue, which makes investment strategy very difficult.
Let me explain why…
Pessimism Goes Mainstream
A dollar collapse, hyperinflation, or a crippling deflation could change everything on a dime.
Not too long ago nobody would consider that a serious possibility.
People believed in the stability of our economic system. They believed in the almighty dollar with controlled inflation.
Pessimism has gone mainstream. The genie is out of the bottle.
Normal people with regular lives who don't live and breathe econometrics fully understand that our current economic trajectory is mathematically impossible. Something has to give.
Governments around the world have played the “funny money” game with bank bailouts, various rescue packages, and other entitlements.
The growth of financial obligations has reached an unsustainable level. There's too much leverage in the system, and there's no mathematical way the debts can be paid back in real terms.
They must either be defaulted in reality or defaulted in kind through inflation. They can't be paid back and they can't continue to grow at their current pace.
Something big is going to happen economically, and the masses realize it now. It's just a question of when – not if.
All the government shenanigans with the bailouts and other nonsense I vociferously objected to on these pages over the years had the exact opposite affect from what the government intended.
They wanted to restore confidence in the system. Instead, they undermined everyone's confidence to such an astounding degree that even I was surprised.
The masses now understand our economy is no longer operating like a comfortable walk in the park, where a misstep results in a dirty knee or a bruised ankle (i.e. – a normal economic contraction).
Now, we're walking an economic tightrope strung between two 40 story buildings where a misstep results in a devastating fall. On one side is massive inflation, and the other is horrifying deflation. Both are bad…very bad.
Each error in judgment causes dreadful consequences, and that's why continued volatility is a fairly safe forecast.
What To Do?
The bottom line is I can't tell you if we'll have inflation or deflation over the next few years.
I've read economic analyses from many extraordinarily learned people who sit on opposite sides of the fence. They are equally convincing.
My belief is inflation will ultimately prevail (10+ year time horizon), but sequencing is everything.
The inflation might be preceded by a devastating deflation first. The only thing I'm confident about is we are in for a wild ride either way.
This is important because it determines investment strategy. If inflation prevails, then commodities, metals, and mildly leveraged income producing real estate (with fully amortizing, fixed rate mortgages ONLY) will be the places to invest.
Under this scenario, cash is trash and real stuff is the best place to be when inflation wins the day.
However, if another round of debilitating deflation strikes first, then these exact same investments could be a very expensive mistake.
Cash is always king in deflation because money becomes worth more in terms of the real things it can buy. For example, just look at how easily real estate investors were wiped out during the short-term 2007-2009 decline. It's because they were invested in real stuff.
Being a couple years off in timing can make the difference between bankruptcy and wealth.
In other words, the economic tightrope produces two mirror opposite scenarios. The correct investment strategy for one can be a nightmare for the other. You can't have it both ways as an investor.
That's why the markets are schizophrenic right now, producing dramatic volatility.
When it appears the government has the upper-hand (inflation prevails), then it's “risk on” and asset prices soar.
When it appears the government is losing the battle against deflation, then it's “risk off” and everyone runs to cash, causing asset prices to free-fall.
Not an easy situation for investors like you and me.
What's Your Solution?
The purpose of this post is to lay the foundational arguments and set the context for discussing how you're dealing with the problem.
What's your investment strategy for this economic tightrope?
Tell us in the comments below. I will then add some coaching questions to each strategy in an effort to deepen the learning.
The goal is to produce some informative and educational insights you can apply. Participants get free coaching and readers get valuable insights.
If you want to follow the discussion, I encourage you to chime in with your own ideas so that you can subscribe to the comment updates and not miss anything. We might just uncover some viable solutions that can help you…
Okay, so who's going to get the ball rolling? How will you manage your investments to protect against inflation and deflation?
Here’s how to make more by losing less…
If you're looking for an investment strategy that goes beyond "buy and hold" while controlling risk and requiring as little as 30 minutes a month to manage, this is the answer. It’s so good I wish I had built it myself. Take back control of your portfolio and start getting results today.
Todd, thanks for addressing our comments from last week. I’ll share what I’ve been doing.
The biggest thing is getting educated. I’ve been studying investing and economics for four or five years. Financial education is huge!
I only recently started to take more control of my financial future by more actively investing. I used to have everything in retirement mutual funds with a little savings in cash in the bank. I finally got fed up after watching my retirement fund get cut in half for the third time (I’ve been building it since 1997). I rearranged my funds a bit while I started studying more, and I rode the bull back to regain most of what I lost in 2008. When the bull faltered a little in mid 2010, I put it all in cash and waited while I studied.
I was fortunate enough in 2008 to have some friends turn me on to precious metal investing, and put a chunk of savings into physical bullion, which has done very well since. If we do experience deflation, I plan to buy a lot more because I agree that inflation has to win the day eventually. The Gov’t needs to cheapen its debts. So strategy #1 is buy physical bullion.
Now I’m more actively trading the accessible portion of my retirement IRAs in a self-directed account. I’m taking advantage of the current bull, but I’m cautious because a correction or bear can start anytime. May have started today in fact. I’m investing in strong companies making new highs, and hedging with commodities. The Dow dropped 178 today, but my commodities soared and my account essentially broke even for the day. I’ll put trailing stops on my winners tonight, and I already have stops on my losers. They just didn’t drop enough today to trigger. So strategy #2 is don’t trust my retirement money to mutual funds and the buy-and-hold mentality. I’m now self directing what I can in stocks and options (after getting educated) and doing buy-and-manage in mutual funds with the rest. These accounts can be moved to cash quickly if the market starts to tank again.
I’m planning on buying some property this year. The one rental house I’ve owned for 5 years or so got hit hard by the deflation, but I was not over leveraged, so month to month I’m breaking even, and I lose a little in the vacancy periods. Now I’m looking at housing that is already on the affordable end that has a high enough return on investment that I have my down payment back in 1-2 years. Using fixed rate loans, on inexpensive property that cash flows like crazy, it seems fairly low risk to me. Another deflation would lower values more as well as rents, so the risk is still there. But I can’t pass up the opportunities and low interest rates. If I wait and years from now I see that it truly was the best time to buy, I’ll never forgive myself. If I buy now and deflation hits, I’ll know at least I was DOING something about my future. So strategy #3 is smart real estate.
The one thing I’ve not done yet that I really feel compelled to do is stock up on food and water and the means to prepare them. My parents got snowed in this past winter and could not get to the store, and when they did the shelves were bare. Imagine what it would be like if the banks closed for a week or a terrorist attacked our power grid or water system. Food and water insurance is how I look at it. So strategy #4 is prepare for worst-case scenarios with food and water storage, and maybe some camping stoves and fuel for them.
I may open a non-retirement brokerage account so not all of my trading is with IRA money. By the way, half of that is 401k, and half RothIRA. I’m hoping the gov’t does not change the law and tax Roth money down the road. In case it does, I’m not putting everything in Roth. If I leave my company, my 401k will be converted to an IRA, but not a Roth.
That’s what I got for now.
Tim
@ Tim – Thanks for starting this comment stream off right. You made a lot of valuable points so let me take them one-by-one…
(1) Emphasize Financial Education – I couldn’t agree more. I believe my personal emphasis on education first has been the source of my wealth (not just financial). I wrote an entire article about the importance of financial education here and the key role it should play in your wealth plans. My strong belief in education is why I send my kids to private schools and why this business is all about education. It pays you dividends for a lifetime and nobody can take it from you or devalue it through inflation. Great starting point!
(2) Buy Physical Bullion – I found your lead-up to the decision to buy physical bullion more interesting than the end result. You started with the active vs. passive investment strategy argument which is the core of my personal answer to the question posed here. It is a subject we will be revisiting at length in future comments (there are three already before I got to reply to yours so I will develop the discussion more in those comments). It is also the question at the core of my personal answer – active risk management. My concern with the “buy gold” solution is there is no risk management. Gold tanked (albeit temporarily) in 2008 when deflation (temporarily) took hold and could tank again. I don’t have a crystal ball. The math of compounding wealth states unequivocally that there must be a method of risk management behind every investment to control losses when you are wrong. Because you cannot manage the risk of holding gold through a valuation discipline (there is no economic way to value gold because it earns nothing i.e. present value of income stream) I personally would want to have some statistically valid way to manage the risk of ownership. Again, this will get developed more fully in future comments.
(3) Buy and Manage vs. Buy and Hold – There are several keys to this approach working. I wrote an article here about Gambling vs. Investing that illustrates the important logic behind this approach. You must have a statistically valid model with a positive mathematical expectation that is thoroughly researched and proven. Then you must implement it with absolute discipline and not introduce judgment; otherwise, you are still a gambler. I have another ebook 3/4 completed called the “Buy and Hold Myth” that explains the fundamental and mathematical problems behind Buy and Hold that you have personally lived through and why your answer is pointing in a valid direction. In the meantime, I have a short article here with some fun teaser ideas to get people thinking. Just to be clear, buy and hold is not broken. I don’t want to stir up a hornets nest with all the buy and hold disciples. It is what it has always been. The problem I have with the strategy is a lack of risk management which violates the math of compounding wealth in real terms. This will be developed more fully in future comments and posts.
(4) Buy Income Producing Real Estate – Another valid strategy, and I appreciate how you covered many of the important aspects of this strategy in your comment. You must use fully amortizing, long-term, fixed rate financing to protect against interest rate risk and it must have a solid margin of cash flow to weather the storm and any future deflation. You also accurately pointed out the risk in this strategy since there is no way to exit on a further decline thus the importance of cash flow margin and financing strategy. I wrote an entire post elaborating on this strategy here for anyone interested in more detail. Very well said!
Tim, thank you for kicking this discussion off right. You opened with the importance of education, owning gold, the role of active management to control risk, and a valuation based, income producing, real estate strategy. Great stuff! Thank you.
@Todd Tresidder: Todd, thanks for the reply and links. I should clarify that I look at “investing” in precious metals really as a better place for savings. It is a store of value, a preservation of purchasing power. I don’t expect to gain or grow from it. Just maintain and protect. If deflation hits, the dollar value of metals will decline, but so will the cost of food, gas, clothes, etc, so my savings has lost no value. Similarly, if inflation hits, and I can’t pay dollars for food because it is so expensive, I can cash in gold to buy food. I’m glad you pointed out how precious metals are different.
I read and appreciated the investing vs. gambling article a little bit ago, but I need to read it again. I’m not sure I followed everything related to mathematical models. I may comment again with questions about that.
Thanks!
@Tim – Thank you for clarifying your point about precious metals. You are using them as “real money” in the truest sense of the word. I understand your point now – it more focused on wealth preservation for the wealth already built rather than a speculative strategy to grow wealth.
All I can say after years of trying more strategies than I care to share is I try not to complicate things. I get where you are coming from and the logic behind it, and the only thing money understands is the math of compound growth equations and that is governed by mathematical expectation. Every investment strategy I employ must demonstrate a provable, positive mathematical expectation because that is how money compounds and grows. It is the set of sunglasses through which I filter every discussion on investment strategy because the math is inviolable.
You want to be cautious of any approach that requires correlations for validity. There are always exceptions.
Hope that helps.
@Todd Tresidder: Hi Todd. I re-read your article on gambling vs. investing, and I understand the concept of mathematical expectation, but I’m having trouble applying it in my mind to an investment product. Would you please provide an example?
Tim
@Tim – Mathematical expectation can’t be applied in your mind – only through research. It is the “science of investing” and produces counter-intuitive results where you can make more by risking less – the opposite of what most experts claim.
It is a function of average gain/average loss and percentage winning trades/percentage losing trades. Most people think in terms of probability or the odds that any given investment will be a winner or a loser. Expectation adds the dimension of average gain/average loss to properly weight long-tail outcomes. It doesn’t just say the odds of winning or losing, but how much you should win or lose instead. It is the equation that determines compound growth.
The key concept is you never want to add an investment strategy to your portfolio unless it improves return for any given unit of risk.
I know this is a mouthful with a bunch of technical jargon, but I’m trying to respect your question without writing an entire blog post on the subject. It will be part of my 7 Steps to 7 Figures group coaching (Step 6 specifically) later this year. In a nutshell, think of it as an actuarial approach to investing.
Hope that points you in the right direction in the meantime…
I can think of three strategies off the top..
1/ The Ivy Portfolio
“>Ivy Portfolio. Basically follows moving averages to get you in or out.
2/ Precious metals. Should do well with either scenario. They will do great in inflation. Esp if you buy some good mining good companies that are under valued. Same as any other company. In deflation holding gold is a bit like holding cash. It will lose some value in the initial deflation impetus but as soon as talk of QE starts up it will take off again. So you want to hold a reasonable proportion of metal along with the miners.
3/ Inflation deflation timer models. A bit like ivy portfolio but more sophisticated presumably.
Of course any company you buy should be well researched and a good value buy.
My guess is that a well thought out portfolio will contain some high dividend mega cap companies like coka cola J & J etc. Some warrents on bullion or such like. Some good miners and explorers.
Having written all of the above it still occurs to me that following something like the magic formula value strategy through thick and thin may still do better if you can stand to take a deflationary hit at some stage. Alternatively you could you could use the Ivy portfolio timing strategy along with the magic formula.
To be honest I am leaning towards just such a strategy. I find holding gold just too boring. It’s rather like macro currency investing for which you need eternal patience in my view.
@Simon – One thing I love about this blog is how it is attracting such high quality readers and comments. These first two comments and all the comments on recent posts show what a quality group of people are participating here. I’m thankful and appreciative. Let’s look at Simon’s suggestions one-by-one…
(1) The Ivy Portfolio I actually do conceptually similar strategies with my own funds and have taught this strategy (or similar) to private coaching clients. A couple of key points to note. The important concept is to employ a mathematically disciplined form of active risk management. The risk management cannot be correlation based only – it must include a price component. Finally, it must be thoroughly researched with a provable, positive mathematical expectation. There are several articles on risk management here that I will be adding to in the future for readers interested in exploring this subject in greater detail. Also, you can pick up Meb’s book, The Ivy Portfolio using this link to Amazon.
(2) Precious Metals should do well in either scenario: The hair goes up on the back of my neck whenever someone tells me I can make an investment where I win with two diametrically opposite scenarios. Maybe that will prove true (I don’t have a crystal ball), but logic tells me otherwise. In addition, precious metals took quite a hit during the 2008 decline. Sure they came back, but that was because the belief is that the Fed solved the problem. Only time will tell, but I personally would not place any capital at risk without some disciplined form of risk management to guard against losses in case you are wrong. My two cents worth.
(3) Inflation Deflation Timer Models – Simon, I would appreciate you coming back and explaining this greater detail. Maybe provide a few examples. Thanks.
(4) Valuation Based Models – Yes, this is another valid strategy although it is important to understand the concept of time frame. Buy and hold is valid on a time frame of 20+ years but offers a miserable risk/reward ratio. Valuation is valid risk management discipline on a 7-20 year time frame and offers an improved risk/reward ratio, but you can still take some interim big hits along the way because it lacks a price-based risk management discipline. Price based model like The Ivy Portfolio are valid on 1-5 year time frames. This is an extraordinarily important concept that took me years to develop, understand, and integrate into investing.
Thanks again for your great input Simon. I appreciate your bringing these ideas to everyone’s attention.
Todd,
I’m an immigration lawyer, and I deal with the government daily for my clients. Government meddling in our economy and other areas of our lives almost always has negative consequences. There is a serious question as to whether or not those negative consequences are unintended. I have tried many investment strategies that did not work out for a variety of reasons, many of which your articles have helped me recognize and understand.
At this point, we are saving as much as we can, planning and getting some good education before making any more moves. The education is helping build confidence that we can actually accomplish our goals, but we have so much to learn still before we take the next step.
Thanks for taking the time to share such valuable insight and information with us. I have learned so much in the past few months thanks to you. I look forward to this discussion chain to hear what actions others are taking in light of the coming volatility. Thanks also to Tim for being willing to share his experience and plans.
@Garry – Thank you, Garry, for joining the discussion and sharing your unique perspective on working with the government. I found your comment, “There is serious question as to whether or not those negative consequences are unintended” particularly thought provoking.
I also appreciate your emphasis on education and thank you for sharing how the insights learned here have helped.
This should be a good discussion with good comments.
Timing is everything and for many of us (myself included), I look back to see missed opportunities and bad timing mistakes that have cost me a fortune or potential fortune.
The silver lining to the current economic environment and market volatility is that many investors are now more actively managing their money and moving away from the passive buy and hold strategy. We are educating ourselves on investment theory and not just blindly listening to the “experts”.
Even if you are not inclined to buy individual stocks, bonds, and commodities changing allocations of index fund portfolios may be a good idea.
I have started digging deep into different investment philosophies and have enjoyed reading various blogs and websites such as seekingalpha.com and passionsaving.com among others.
The concept of PE10 which is the Schiller SP500 index is very interesting and helps measure the degree to which the market is overvalued.
I also think some investors may be tempted to overly manage their investments as well. This could take the form of overtrading their account, engaging in risky spectulative trades that they may have no business making. Their are many fear mongerers lurking today that make us feel like the end is near. It has been difficult to tune them out sometimes.
I am focusing on increasing my income day to day, saving more, and doing my best at stayind diversified. More education is key and it is important to have a well thought out plan instead of reacting to the market on a day to day basis.
This may be too philosophical but you have to look at the big picture and really decide what you want your “retirement” to look like.
I personally hope never to “retire”. I want to expand my skills and areas of knowledge so I can be teaching, thinking, serving until the day I die. I want to have enough passive income to allow me to do this on a part time, on my own schedule basis. I think the constant worrying many people have of needing 2.2 million in your portfolio is somewhat unfounded.
@Kevin – Thanks for your input. You bring up some really compelling points that I would like to emphasize…
(1) Shift from Passive Buy and Hold To Active Management: This is a many-layered discussion. First off, I support active risk management as explained in other comments to this post because it creates a more favorable risk/reward ratio and allows me to sleep better at night. I simply cannot stomach the horrendous drawdowns and prolonged periods of poor performance consistent with buy and hold – even if they are only temporary. It is a personal preference. The difference is I have advocated this position since the early 1980’s when I spent a decade researching investment strategies for a hedge fund and I have never found any research that would change that position. The recent shift of the masses to active risk management from the popularity of buy and hold in the 1990’s is a cyclical thing that has been going back and forth forever. After prolonged run-ups in the market everyone is a buy and hold advocate. After prolonged sideways periods (lost decade) or serious bear markets the masses shift to active risk management. Witness Gerald Loebs famous The Battle For Investment Survival written in the middle 1930’s following the Great Depression. Sometime during the life of this blog the markets will have a bullish run again and everyone will be a buy and hold advocate again. The key is to have a disciplined investment style you can stick with and not shift with the seasons. You have to figure out what works for you and understand why. This is something I teach my money coaching clients and will be teaching in steps 5 & 6 of Seven Steps to Seven Figures group coaching when it launches later this year. So anyway, I support active risk management, but more importantly, I support picking an investment discipline you can stick with through all the seasons of investing. Active risk management just happens to be my choice for reasons discussed in these comments.
(2) Schiller P/E 10 – This is valid indicator illustrating the general concept that 7-15 year holding period returns are inversely correlated to valuation at the beginning of the holding period. Ed Easterling has some brilliant work in this field I highly recommend every reader learn more about in the following two books: Unexpected Returns: Understanding Secular Stock Market Cycles and Probable Outcomes I couldn’t recommend his books more highly for understanding these principles. John Hussman has also written extensively on this subject and is recommended reading. The key thing to note with valuation based disciplines is they can be wrong for prolonged periods of time before they are right which can be very frustrating to deal with in real time. (see my earlier comment on the valid time frames for each risk management model)
(3) Avoid Overtrading : Absolutely yes! I agree completely. I’m glad you added this to the discussion because it is a danger when people shift from passive to active investing. As stated earlier, it is important to pick a discipline based on thorough research with a proven, positive mathematical expectation (the basis of all sound investing) and stick with it. You must have a discipline. Do not invest based on news, trends, or any of the usual stuff discussed in the media. (See this article for more information on this subject)
(4) I appreciate your personal philosophy on focusing your life on what you can control and not letting all the noise and doom-and-gloom stuff get in the way of moving forward. I’ve had to do the same thing. It can be a challenge, but I’m happier for the change. I also appreciate your ideas on retirement. This blog is essentially my version of what you are discussing in your closing paragraph. I’ve tried full-time retirement and full-time leisure, and the best answer I’ve come to is the balance in between which I call a “lifestyle business”. Thanks for adding this idea to the discussion.
Thank you again to all these great comments. I’m really thankful for the group of readers this blog has attracted. I’m looking forward to the next addition to this discussion…
Hi Todd,
I thought I should explain the magic formula a little further. It was developed by Joel Greenblatt of Gotham Capital fame. His fund ran for ten years and had 50% average annual returns for the full decade. This essentially passive strategy involves using a filter and ranking system to identify 50 stocks that are good value and good companies. The good company criteria is based on the company having a history of high returns on capital. Four times year you buy six or seven companies randomly selected or not as you prefer. After one year you end up with 30 companies. You then start selling the companies that you have held for a year and buy new ones. It is not a buy and hold strategy. You sell the ones that have lost money just before a year is up you sell the ones that made money just after a year is up. This strategy has had back tested compounded annual returns of about 30%. It has never lost money in any three year period and has only lost money one year in six. You still suffer from market risk but if you stick with it you should more than make up your losses on the inevedable rebounds.
@Simon – I’m not intimate with MagicFormulaInvesting so I can’t say one way or the other. Here are the things I like about what you said…
It includes a valuation discipline.
It has a specific buy/sell discipline with exact rules.
It is active instead of passive (but not too active).
There is a method for pruning losers.
These are all positive attributes for any active investment approach.
Again, I have no idea if this program is any good or not since I have not checked it out.
Thanks for sharing…
HI Todd,
Thank you for the great discussions. I am glad that your entire site is not like this post because my eyes are starting to gloss over at the all the technical jargon! To be honest I tried to learn as much as I could during the 1990s about stock market investing and I read many books on the subject. I started with stock mutual funds and eventually ended up in individual stocks thinking that I could invest as good or better then the pros could. Considering most of the pros were not beating the market averages or if they did it was only for a short time period of time. This was late in the 1990s and I got heavy into the internet infrastructure stocks that collapsed when the dot com bubble burst. I held these stocks for a decade only to realize that many were not going to return to their former highs or just stay even ie MSFT or CSCO ect ect.. During that time I also built a portfolio of DRIP stocks large companies like XOM, HD, AFL, JNJ, PG and Coke. These have consistently added more shares due to dividend reinvestment and small growth. They have at least keep up with inflation. After the latest financial crash and govt. bail out of the banks I really lost faith in the integrity of our financial system in the US. I really feel like the system is rigged in the investment banks favor. I resent the system so much I don’t want to commit any sizeable amount of my future net worth to it. This brings me to real estate. I guess we all have different characters and mine just seems suited to this kind of investing. I feel like I have some measure of control with real estate. I own, manage, and market my own properties and have a real sense of control of what I am doing with it. I have never felt this way about the stock market. I have never consistently made 20% + yearly returns in any investment other than real estate. Like you have mentioned in your article above you do not need many real estate deals to do well, just make sure that they have good cash flow. I have lost hundreds of thousands of dollars in equity in the last few years but it does not matter to me because all of my properties are providing excellent cash flow. Every purchase is closely scrutinized to ensure excellent cash flow before ever purchasing. I look at each new purchase as a self supporting business unto itself. I would like to learn more about some of the investment methods discussed above but I feel like the time and energy spent doing it I could make much more in real estate. With the tax advantages ie depreciation, available leverage via long term loans, income and cash flow potential I see no other option for me to combat the future loss of value in the US dollar. Thanks again for your insightful blog and for all of the great comments.
Steve
@Steve – Thanks for sharing your ideas. It sounds like you have a strategy that fits you well and you are managing it effectively to produce cash flow. If it’s not broke don’t fix it. This is a solid “anti-dollar” strategy with the key requirements being long-term, fully amortizing, fixed rate financing and a solid safety margin of positive cash flow to carry you through any interim difficulties. The biggest downside is the work involved in managing multiple properties which can turn into a business in itself.
Overall, the goal is to find a strategy that fits you well and can be implemented with discipline and consistency. It seems like you have found yours based on what you’ve written here. Congratulations, and thanks for sharing.
Hi Todd,
Yes. I did receive the newsletter. Thank you for asking. In fact, I’ve made a folder specifically for Financial Mentors e-mails and newsletters so I can refer back to them.
I am considering about investing in money-market accounts, again, as soon as I start back working. What is your opinion about money-markets in this economy? What are the best/worst ones?
I’m looking forward to what you have to say, and more of your newsletters.
@Jeannine – I feel honored that my writings are worthy of saving for future reference. That’s nice to hear.
Regarding money market mutual funds, their primary function is a temporary, liquid storage place for wealth earned elsewhere. They are not a wealth building vehicle in themselves. Think of them as a safe, liquid parking place until something more compelling comes along. They are a low-risk hiding place.
I don’t recommend specific investments on these pages so I can’t tell you best/worst ones. In good times I feel confident with any of the major company’s money funds, and in bad times (deflationary declines) I park funds strictly in Treasury-Only Money Market Funds to avoid default risk.
Hope that helps…
I’ll try and add a few points to what has already been written in this blog.
By way of background, I invest and manage my financial life primarily on mathematical expectation, risk management techniques, and historical data from past stock market manias, crashes, and panics.
I also worked 16 years in public pension administration. One of my duties involved working with actuaries. Actuaries use demographic and financial data to develop economic and pension liability assumptions. They use Monte Carlo simulations and other risk management tools to help identify and manage risk. Their risk management tools are far from perfect. However, these guys are some of the smartest people on the planet. They review thousands of economic variables including educated guesses about long term stock market returns and future unfunded liabilities. I’m a big fan of smart actuaries.
No one has a crystal ball and no one can predict the precise time of a crash, inflation or deflation. However, like an actuary, you can think through and prepare for multiple economic scenarios. For example, most people don’t realize that between 1930 and 1940 there were 6 years of deflation and 4 years of inflation. Inflation and deflation is not an either or question. You have to plan for both scenarios. Actuaries know this and plan for each scenario in their financial simulations. The best actuaries also know that state real revenue growth over and above inflation and population growth closely aligns with the general rise or fall of investments in the market. As a side note, study this incredible correlation sometime. There is a clear correlation between these two factors.
We are likely to see both inflationary and deflationary environments in the next 15 year period. I lean more toward the inflation camp like Todd. However, I think it is important part of risk management to prepare for all possible major economic scenarios. I don’t have room to write about all that we’re doing to prepare for each scenario in this blog. However, here are a few strategies for each economic season:
Inflation
Check out TIP bonds only in an inflationary environment
Research the benefits of TIP bonds for mild inflation. However, remember that TIP bonds are virtually worthless in hyperinflation because they adjust too slowly to protect you.
Make sure your insurance is up to date
Check your insurance policy limits especially your home owner’s policy to ensure that the policy limits are indexed to keep up with inflation .You don’t want to be underinsured in an inflationary environment.
Do your homework on Gold as a hedge against inflation
I’m generally not a gold fan as a hedge against inflation. Gold prices peaked adjusted for inflation in 1980. In my view, Gold is overpriced compared to its historical real value. The pro’s and con’s of buying gold as a hedge against inflation is a great topic for a future article. There are state usury laws that make gold very risky in an inflationary environment. The long- term capital gains tax is also a con of Gold.
There is no room in this blog post for a detailed discussion about two way indexed assets that may work in both inflationary and deflationary environments. However, this subject is a great article for a future post.
Deflation
Paying off your mortgage is diversification strategy
I look at the concept of diversification a little differently than most people. Part of “diversification” to me is being debt free. We paid off our mortgage when I was in my 40’s. Mortgage comes from the French word ‘Mortir’ which loosely translated means until death. Paying a mortgage until death does not sound very appealing to me. The people that thrived in the Great Depression were generally mortgage and debt free. There expenses were low. We live in a no debt zone and are 100% debt free. I like the feeling of owing no man.
Study the pro’s and con’s of home equity insurance
Keep tabs on the development of ‘Home equity insurance” in the marketplace. The basic principle is that if the housing market crashes you can “Hedge against the decline of home values” by purchasing this type of insurance. This type of insurance is in the experimental and pilot phase (therefore, I would never buy it now). The equity protection plan started in about 2002 in New York. You may want to google “home equity insurance” to learn more about this emerging concept. Also, pay close attention to the case/shiller index of home prices. Shiller’ P/E 10 concept is a good stock risk management tool. However, his work in identifying the true value of regional housing prices is an even better risk management tool.
Hyperinflation
Research the value of FDIC-insured money market deposit accounts (MMDA accounts)
It makes sense to me to keep some funds in FDIC-insured money market deposit accounts (MMDA accounts) in a hyperinflationary environment. They are set up differently than TIP bonds and may give keep up with the pace of hyperinflation better than TIP’s. MMDA accounts are generally for liquidity to pay your bills.
Zero personal debt
If you have zero debt, you have a much better chance of surviving financially in the deflation zone. I’m a zero personal debt fan—zero personal debt is a risk management strategy.
Study the distinctions between non recourse and recourse debts
Research the difference between recourse and non recourse debt. How you choose to pay off your debt (the sequence) is a big deal to your financial future. The difference between the two types of debt would make a great article in this blog.
New cash management systems
Create a new cash flow management system for all business and personal expenses. You basically have to get rid of all bureaucratic cash management procedures in a hyperinflation environment and replace them with fast payment systems because your money loses value rapidly—in extreme cases your money loses value daily or even hourly.
Hope this helps someone
Larry
@Larry – Thank you for adding these concepts to the discussion.
I see several interesting ideas for deflation or inflation, but the challenge is many of these choices will lose if the opposite scenario develops. In other words, if you are long an inflation type asset and deflation hits first how do you manage that risk? Are you basically building a portfolio that contains both types of assets simultaneously or is your approach different?
Also, I would be very interested in hearing more about the “two way indexed assets that may work in both inflationary and deflationary environments”.
Thanks.
If you can’t control or forecast a specific event then the best option is to have specific strategies to mitigate the anticipated risks. For example, if you live in an earthquake zone, you probably should purchase some form of catastrophic earthquake insurance. You can’t insure yourself against every risk. However, it makes sense to insure yourself against the big risks. If you live in the Northwest near a river, it makes since to have flood insurance. In addition, everyone should probably have some kind of fire insurance. You may never need the insurance but you’ll save your financial life if a catastrohic event occurs.
It is the same thing with inflation and deflation. They are potential catastrophic risks in our society. I believe our current economic policies are unsustainable because of all the entitlement programs, unfunded liabilities, trillions in derivatives, and bail out debt. My risk management assumption is that history will repeat itself in my lifetime. Large institutions will continue with their financial engineering strategies. The moral hazard will prevail. In the end, they’ll be bailed out again. In general, I don’t trust that large financial institutions have learned much of anything from their mistakes other than to come up with new “financial engineering strategies”. Systemic risk will continue.
My insurance policy tells me to owe no man in the current and projected economic environment. Risk management to me is having no personal debt because of the huge liabilities in our financial system. This may sound like a simple strategy. However, it is my number one financial risk management strategy. Said another way, it is my insurance policy. “The borrower is the lenders slave” never rang more true than in the “great recession”.
Having no personal debt works well in deflation, inflation, and hyperinflation because you don’t need as much money to survive financially. I’ll stick with the no personal debt strategy. This may be a conservative approach but I’m pretty conservative financially.
If severe inflation happens, dollar denominated assets will decline in value. Having no debt helps mitigate this risk for me because I have more monthly cash flow. If deflation occurs, it’s easier to pay the bills. It may be a simple approach but it works.
Next, certain defined benefit plans mitigate the risks of inflation and to a lesser degree, deflation. Some of the older defined benefit plans are 100% aligned with the movement of the CPI. For example, if the cost of living goes up 16%, the corresponding retirement benefit goes up 16% as well. On the other hand, the original retirement allowance in some plans can’t fall below the original retirement allowance e.g., if the original (emphasis added) retirement allowance is $3,000 per month, the original benefit payment stays the same even though deflation is 5%. I realize that most people do not have defined benefit plans. However, I bring this up because inflation/deflation strategy planning is different for those that have defined benefits plans versus defined contribution plans and/or real estate as the backbone of their financial plan. One size does not fit all.
Another simple risk management strategy that applies more broadly is to buy major items now if you believe inflation is likely to occur in the near future. For example, I think we are on the cusp of higher inflation so therefore, my risk management strategy is to pay cash for a new roof late this spring or early summer while the dollar is worth more. management.
I already mentioned the MMDA account strategy. I remember the 1980’s when we had high inflation. These accounts or similar accounts will not make you a lot of money. However, they generally keep up with reasonable inflation. In addition, all personal insurance accounts should be indexed for possible inflation/deflation. I see this as a risk management strategy as well.
I’m running out of time to write today. However, I think we need to keep this blog discussion going for a couple of weeks because there is so much more to say about possible ways to protect yourself financially in deflation/inflation. For example, some 529 college savings plans are in trouble. In our state, the promises of these plans are guaranteed. However, in most states the promises are not guaranteed. If I lived in another state, I’d be analyzing how to protect my money in these types of plans. They are running deficits and not keeping up with college tuition inflation.
@Larry Weber – Thanks for clarifying. I’m really glad you added these ideas to this discussion because they bring up a very different viewpoint from previous comments.
What I’m hearing in your viewpoint is a focus on cash flow and survivability more than a focus on asset purchasing power growth. This is not a criticism because it is a perfectly valid viewpoint depending on your current wealth. If you already have “enough” then this position is perfectly logical and your strategies are totally valid. For those readers still struggling to achieve wealth this strategy probably won’t reach the goal. In other words, it all depends on what shoes you stand in today.
A simple analogy can be applied to stock analysis. A highly leveraged company (lots of debt) can provide extraordinary returns (growth of equity) during boom times but blow up almost instantly during deflationary declines because there is little margin for error due to the leverage. Whereas, a company with no debt may not provide the same leveraged returns on the upside but has little risk of destruction on the downside.
You are building a no-leverage wealth preservation model by paying down the house and focusing on minimizing cash flow needs. You’re stalemating both deflation and inflation. The implied reality of your situation based on your strategy is that you already have somewhere near “enough” so the focus is more on risk management than asset growth in real terms.
Other readers who have not already achieved “enough” must figure out a way to grow wealth in real terms during these difficult times to reach the level you have already achieved. That is where some of the other models discussed previously apply.
So thank you for illustrating another viewpoint that many readers can apply if their situation fits.
The lesson to be learned here is one size does not fit all. Each personal situation is unique. The key is to find the right strategy for your situation.
Todd,
You’re right about our financial situation. We are in a wealth preservation mode. Growth is secondary. Thanks for allowing the expression of different viewpoints in your blog.
During the depression in the United States, there was deflation and a loaf of bread was about a penny. The penny was scarce. There were no jobs and no one had money to spend.
Germany, on the other hand, had hyperinflation. A loaf of bread cost a wheelbarrow full of their currency. There were jobs but money earned was not worth much.
It seems to me in both these instances, tangible gold would be a valuable thing to have and not a poor investment. I am trying to link history to the question of which way our economy is heading, towards deflation or inflation.
I would appreciate anyone’s comments on this as I am getting into the economics game late.
Thanks
Awesome ! very interesting :
Being a Beginner, with a lot to learn about the intricate investment details involved, I am going to cop out and suggest that staying the course, with a well-balanced portfolio of index funds and steadily producing dividend stocks, will probably keep an investor somewhere in the middle during inflationary and deflationary times. Was that a compound sentence (ha!)? Is that a B- answer? And why?