You’ve probably heard the advice, “Don’t stash your cash under the mattress”. If you ask why not, you’ll be told that the value of the cash you’ve stored will depreciate over time as inflation rises. This premise, long upheld by the investment banks, has led individual investors to believe that they have to stay invested in the market at all times in order to keep ahead of inflation.
This is one of the many investment myths Squire Asset Management strives to clear up for investors. Simply put, it’s false.”
While the theory holds true for inflationary markets, the exact opposite is true of deflationary markets where the return on cash often exceeds returns on other asset types. Here’s how it works.
Inflation vs. Deflation—The Basics
Inflation measures the change in the cost of goods and services over time. It is represented by the annualized percentage change in a general price index, usually the Consumer Price Index. Over the last 100 years, the cost of goods and services in the United States has risen by an average of three percent annually. As inflation increases, the purchasing power of each unit of currency (each dollar) decreases, so a package of gum that cost 25 cents in the 1970s costs one dollar today.
Deflation, most commonly associated with periods of market depression, occurs when the costs of goods and services decrease and the inflation rate effectively drops below zero. Decreases in the money supply, government spending, consumer demand (influenced by population growth or decline), and/or business investment are all possible contributors.
Throughout the 19th century, inflation and deflation cycled regularly, but since the abandonment of the gold standard in 1948, the U.S. economy has enjoyed more than 60 years of price increases. Unfortunately, it’s impossible for this trajectorya to continue indefinitely. Some analysts point to minor deflations in 2009 and 2015 as a sign that a longer period of deflation may soon be on its way – possibly affected by the mass retirement (and therefore spending cuts) of the Baby Boomer generation.
The Dynamics of Deflationary Markets
On the surface, deflation may appear to have a positive impact. After all, when prices rise beyond what consumer demand can sustain, the market needs a correction. Lower prices precipitate a relative rise in the real value of the currency, making consumers wealthier and able to purchase more. A boon to the economy, right? Not exactly. Deflationary markets tend to fall into what is called a deflationary spiral.
Lower prices quickly translate into lower company profits, and this has a negative knock-on effect. Companies declare bankruptcy, lay off workers and slash wages, leading to high unemployment and reduced consumer spending. Prices drop further, and the spiral continues. Governments usually attempt to right the economy by lowering interest rates to encourage spending, but as seen in Japan in the 1990s, it can take well over a decade for prices to recover even at a zero percent interest rate.
Inflation, Deflation and the Mattress Myth
So what does this mean for investors? During inflationary markets, investors look to assets that will retain or grow in value, such as stocks and property. They borrow money to invest knowing that rising inflation will lessen the real value of the amount they’ve borrowed. In short, you don’t want to leave your cash under the mattress where it will lose value, you want to use it to buy stocks where it will gain value. A wise play.
However, when the economy transitions from an inflationary to a deflationary market, the deflationary spiral will cause investors to lose confidence and pull out of the market. Stocks, property, and bonds drop in value. Meanwhile cash (possibly gold, digital and other forms of currency) increases in value as prices drop, offering higher returns than the falling assets.
A deflationary market therefore requires a complete reorientation of your investment strategy. Money under the mattress is now the wise play, so you buy a bigger mattress! Eventually as prices move towards an equilibrium reflective of actual supply and demand, deflation will lessen, opportunities will arise in some asset categories, and you’ll have plenty of cash to invest.
Depreciation—Where the Mattress Myth Does Not Apply
Separate from the macroeconomic cycle of inflation and deflation is the constant up-and-down pricing cycle that exists within our current market. Even in an inflationary market, not all goods and services increase in cost, nor all capital assets increase in value over time. For example, since 1900, the cost of making a phone call has fallen by 99 percent and the cost of owning a basic car has decreased by 50 percent.
Investment companies frequently use the “don’t-stash-your-cash theory” to reinforce a buy-and-hold strategy that encourages investors to remain invested instead of investing in a depreciating capital asset (cash). This is a case of investment companies using one myth to reinforce another myth (that buying and holding is the best way to earn returns) so that they can continue to earn fees.
The reality is that, even in times of inflation, if stocks within a specific industry, sector or country are decreasing in value, cash at no return is better than a negative return.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.
No strategy assures success or protects against loss.
Stock investing involves risk including loss of principal.
Article tracking number 1-480961