Stagflation can be one of an investor's worst enemies. However, it is the common lack of understanding of stagflation that can be most detrimental to an investor's investment portfolio. Learn how to invest and hedge against stagflation with mutual funds.
Definition and Examples of Stagflation
Stagflation in an economy exists when there is a combination of stagnation (slow or no economic growth) and above-average inflation.
Normally a slow economy reduces consumer demand to the degree that it keeps prices from rising and thus keeps inflation low. Prices are kept from rising because there are too many businesses competing for too few consumer dollars.
However, prices can still rise as unemployment remains high because the Federal Reserve can increase the cost of money by raising interest rates. Stagflation is rare but can do long and deep economic damage because businesses tend to reduce expenses by eliminating employees. High relative unemployment continues to minimize or reduce consumer demand, which then places more pressure on businesses to reduce the workforce. If the government fears inflation and continues to increase interest rates, stagflation can persist. Stagflation, therefore can be a self-feeding condition.
The most common example of (and first use of the term) stagflation is the recession of 1973-1975, where inflation rose rapidly as US economic growth, as measured by Gross Domestic Product (GDP) shrank. An extreme example of stagflation is Zimbabwe in 2004. (hat tip to About.com Economy Guide for article on Stagflation).
Stagflation Investment and Hedge Strategies
The best-known strategy for hedging (protecting) one's investment portfolio against stagflation is to invest in "real assets" whose growth is not dependent on a growing economy. The most common examples of these real assets include commodities (especially gold) and, in some cases, real estate. For mutual fund and Exchange Traded Funds (ETF) investors, the most accessible investment vehicles are sector funds. Other sectors that can do relatively well in weak economic environments include health, utilities and non-cyclical stocks.
Tip and Caution
Trying to navigate market and economic conditions with investment strategies is a form of market timing that carries 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.
The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.