What are the biggest threats to your investments? Double-digit inflation? Devaluing of the dollar? Another stock market crash?

24-hour investment stations need to find something sensational to discuss every hour. The recent debate between economists is whether or not the US is on the verge of massive inflation or substantial deflation. As is the case with most financial discussions, a little knowledge can be a dangerous thing. A false distinction is potentially harmful for investors and shoppers who think they must decide which of the two outcomes is going to occur first, then act swiftly to avoid the potential damage.

The purpose of this article is to give you a better understanding of what inflation and deflation are, explain the investment risk associated with each, and share a few suggestions on how to hedge your bets so that your portfolio is not unnecessarily at risk.

What is inflation?
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. Inflation is the idea that a dollar buys less today than it did at some period in the past. In other words, inflation was illustrated by your parents when they said, “When I was a child, a Coke was only 5 cents.” This is the normal trend over time with an average inflation rate of approximately 3% over the last 70 years or so.

What is deflation?
Deflation is the relative decrease in costs of goods and services in an economy over a period of time. This means you can buy MORE with the same dollars. Currently, economists generally believe that deflation is a problem in a modern economy. Deflation is correlated with recessions including the Great Depression.

As an investor, you could be living in a time when the economy is subject to inflationary forces, but certain investment classes face deflationary influences. This creates an opportunity we will discuss later in the article. Before we get to our suggestions, let’s explore a few arguments.

Strong Arguments on Either Side
Both sides of the inflation vs. deflation debate can make a strong case. As a people, we have a huge amount of spare investment capacity in the economy caused by the collapse in demand. High unemployment, low levels of consumer confidence, and increased skepticism with investment advisory firms (see Goldman Sachs congressional hearings, Madoff, Stanford, etc.) are all factors in consumer reluctance (or inability) to make investments. When less money is available for investment, the result is declining prices of those investments. These factors support the argument that we are in a deflationary period.

Despite the macro-economic factors that are pushing the economy in one way, the banking industry has the ability to make changes that can impact the economy and its direction. The central banks appear determined to forestall deflation through an increase in the supply of money and a decrease in the cost to borrow that money. Interest rates are at a record low and are likely to stay that way for a while. When it is easy or cheap to get your hands on money, it is referred to as “Loose” monetary conditions. Loose conditions make it easier for people and companies to buy things (with other people’s money they have borrowed). The more buyers there are, the more natural it is to experience inflation. More money = more buyers. More buyers = higher prices of goods.

Despite the best efforts of the banking industry, stagnant home prices and unemployment near 9% have made deflation much harder to shake than many would have guessed. Optimists believe that rock bottom interest rates and massive stimulus programs will eventually cause inflation to pick up speed at some point.

How to Make an Informed Bet on the Economy Today
We believe that short-term deflation will be followed by long-term inflation. However, predicting WHEN the pendulum will swing in the other direction is a guess at best. What you must realize is that in periods of deflation (recession) or inflation, the risk inherent within each asset class is magnified. Recessionary forces create certain challenges and often lead to consolidation within each industry. Inflation can have a similar impact, as many companies will struggle with increased costs of labor, raw goods and financing.

In short, you can expect the best run companies to capture significant market share as the economy swings from deflation to inflation. Many poorly run firms will ultimately fail. The impending economic changes are likely to reward investors who make the best choices within each asset class – be it equities, bonds or hard assets – over passive investors who choose more general index-based investing that follows the market as a whole. Think of the end of the “dot com” era. Amazon, eBay and a number of other firms flourished while hundreds of others failed. Good advice and valuable research will be very important.

The Cost of Waiting to Invest
If you are putting all your money in cash to avoid risk and inflation is the outcome, you will lose significant buying power with that cash. In other words, if everything increases in cost by 7% (inflation) and your money in the bank grew by 2%, you would lose 5% of the buying power of your cash.

Alternative Investments may hold the Key
Gold, oil, natural gas – all purchased through the use of individual stocks and/or exchange-traded funds – could be a welcomed addition to your portfolio in the face of uncertain inflation or deflation. Foreign currencies (exchange-traded funds and structured notes) are also an option for a bearish dollar trade in your investment account. Many of our clients have been exploring and investing in these investment classes as a hedge against inflation and movement of the value of the dollar against other currencies.

Other popular investment strategies include programs that are not traded on a public exchange like the New York Stock Exchange. Non-traded real estate investment trusts, leasing funds, and oil and gas drilling programs are a few examples. Given recent market conditions, many investors have been attracted to non-traded programs because they offer a certain level of stability.

Conclusion – Avoid Devastating Mistakes
Inflation is likely to punish anyone—and any company—that is not in good financial shape. One of the biggest problems that inflation causes is uncertainty. Commodity markets are currently priced assuming future "hyperinflation," while the prices on bond markets predict little or no inflation. One of them has to give, but we won’t be able to tell who the winners and losers are for years to come. Inflation deals a wild card, making it much harder to anticipate the direction of the economy and the markets. Make changes to your portfolio now so you will be better prepared for the volatility ahead. The authors welcome your questions. You can contact them at (877) 656-4362 or via email at kim@ojmgroup.com.

*Christopher Jarvis, CERTIFIED FINANCIAL PLANNER­™, is a mathematician and financial consultant to doctors. He has co-authored nine books for doctors and spoken to hundreds of groups nationwide. He now lives in the Dallas/Ft. Worth area. Learn about his unique perspective and process at www.jarvispartners.com or call (817) 749-5000 for a free consultation.

Kim Renners ** is the Director of Wealth Management at OJM Group in Cincinnati, Ohio.