Afraid of deflation? Here's what to do

Some stocks are more vulnerable to deflation than others. Companies sitting on piles of cash could actually benefit, but highly leveraged companies involved in things like commodity production are vulnerable. Similarly, consumer goods makers -- especially those in nonessential luxury products -- are likely to lose their power to raise prices. Declining sales and profits would obviously put downward pressure on share prices.

What about winners?

For starters, winning strategies include investments that pay you fixed income over the long term. Some examples are high-quality corporate bonds and municipal bonds. The default risks are going to be relatively low, particularly if you invest in them through bond funds, which will have a diversified portfolio of holdings.

Another thought is the plain-vanilla FDIC-insured certificates of deposit. Yes, the returns might seem low. But look behind the numbers to get the real rate of return: If prices are deflating 2 percent annually, a 2 percent CD is actually paying 4 percent. If you think deflation will last, lengthen your maturities.

Are there still risks? Obviously. With corporate bonds, if deflation begins taking the economy down, default risks rise. With CDs, you could miss an opportunity if you are stuck in a low-yield holding pattern when inflation returns, an event that would likely usher in higher interest rates.

As always, Treasurys are about as low a risk as you can get. Some even point to Treasury Inflation-Protected Securities, which periodically adjust the principal to account for inflation, as a deflation hedge. According to the U.S. Treasury Department, if deflation occurs, the principal on your TIPS is adjusted downward, which means you will get paid less interest while you hold it. However, if at maturity the adjusted principal is less than the original value, you get the original amount.

One final thought: Just keeping your portfolio in cash isn't the worst idea. Deflation is a case of dollars rising in value. Having cash can help you weather the storm. It means you aren't spending it on something that will cost less tomorrow, and you will have capital to deploy once you think prices have hit bottom.

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