How to prepare for deflation

For years financial experts have told investors that inflation a rising costof living is their biggest enemy.Small wonder.

Since the end of World War II, Britain has only seen prices fall (deflation) on an annual basis in 1959 and 2009. On both occasions the fall was brief for the rest of the time prices have been rising. And investors are right to fear inflation.

Put simply, it means £1 in the future will buy less than it does today. So you need your savings to grow more rapidly than inflation if you want to increase your purchasing power in the jargon, you need to earn a real' return.

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A diversified portfolio set up to do this might consist of a mixture of shares, inflation-protected (index-linked) bonds, property, precious metals and maybe commodities for the more adventurous.

Here at MoneyWeek, we agree that rising prices are more likely than falling ones over the long run. That's because central bankers and governments fear deflation more than inflation.

Falling prices may seem like a good thing, as goods become cheaper.And if you're not heavily in debt and you have savings and a relatively secure job, then deflation doesn't need to be the nightmare it's often portrayed as.

But for indebted individuals and economies like ours, deflation is a problem. Falling prices often mean lower profits, lower wages, and therefore lower taxes. That makes it harder to pay the interest bills on borrowed money.

In a world with a lot of debt, this is to be avoided if at all possible which is why British and American central bankers have gone to the extremes of printing money and slashing interest rates to near-zero.

Yet, while prolonged deflation seems unlikely in the UK at least it's not impossible. Japan has been fighting deflation for most of the last 20 years. Prices are now falling in Italy and many parts of Europe.

Even here, inflation remains relatively low by historic standards. So it might be a good idea to build some deflation-protection into your diversified portfolio, just in case. But how?

Cash

During the last five years, the general view has been that cash is trash' and that shares have been the only viable investment for anyone hoping to make reasonable returns. This has proved to be largely true, especially as the interest rates on cash have been virtually non-existent after accounting for inflation, most cash savings will have lost money.

But in a world of deflation, cash comes into its own. If prices are falling at a 2% annual rate, for example, then even if your cash savings account earns 0% interest, that's a real' return of 2%.

High-quality corporate bonds

It has become a lot easier for private investors to buy individual corporate bonds. Deflation and debt are not usually good bedfellows deflation usually goes hand in hand with a weak economy, which means falling profits and a higher chance of companies going bust.

But buying the debt of top companies with strong businesses and sound finances is a good idea. These firms should be able to keep paying the interest on their bonds and to repay them when they mature.So buying and holding bonds to maturity could give you a positive real return.

Government bonds

Deflation often means falling tax receipts. This should make it harder for a government to pay the interest on its bonds. For countries in the eurozone that can't print their own money to pay the bills, this is the case, and their bonds should probably be avoided (at least until the European Central Bank guarantees to buy them).

But countries such as Japan, the UK and America which can print money to buy their ownbonds are different. Their government bonds could become more valuable in a deflationary world.

Any income payment above 0% becomes increasingly desirable in deflation. So as investors anticipate deflation, they buy bonds, which means their prices rise and their yields (the annual interest payment as a percentage of the price paid) fall.

Just look at what's happening today Japan's ten-year government bonds yield around 0.5%, while Germany's yield 0.9% (if held to maturity). This compares with around 2.4% for similar bonds in the UK and US, where deflation is not yet such a threat.

If deflation does rear its ugly head, there is still scope for UK and US yields to fall and for bond investors to profit. The biggest gains could be for bonds with the longest maturities, as their prices are more sensitive to interest-rate changes (they have longer durations').

Shares

In general shares don't do well in deflation but some can prosper. The shares of heavily indebted companies are best avoided, but companies with a steady demand for their products could protect your money quite well.

Health-care and pharmaceutical companies are possible examples, especially as many pay decent dividends. And technology companies have dealt with falling prices for years as improvements and innovations bring down costs so leaders in the sector may still be able to grow or maintain profits in a deflationary environment.

Cut your debts

Falling prices and the knock-on impact on wages make it harder to pay the interest on borrowed money. If property prices fall too, then the amount of equity in your home will also drop, which can make it harder to get a good rate on your mortgage.

Overpaying your mortgage can be a very good strategy in most cases, but becomes even more valuable in a world of deflation. The same goes for any credit-card and car loans.