More reasons to build a diversified stock portfolio.
I read this article on Motley Fool that reminds us just how important it is to diversify our investment portfolios. A pure U.S. stock portfolio will make you pretty vulnerable right now. Why? Because of the threat of inflation. And if it’s not that, you can also worry about deflation, which can also be devastating to your investments.
Here’s why inflation is so tough on our domestic equities. With costs for doing business rising across the board, it begins to put a damper on companies and their performance. That’s one way of looking at it. Another way to look at it is this: the stock market rises when it faces a recessionary environment and falls in a stronger economy. This is because the stock market looks ahead: during a slow economy, the market expects the Fed to take on an “easy credit” approach and will expand the money supply. When inflation is around, the Fed will instead control interest rates and the money supply, by tightening.
On this note, there’s an economics professor named Charles R. Nelson who’s come up with this interesting trading rule that is based on the relationship of the consumer price index and inflation:
“When CPI inflation is on the rise, stay out of stocks; when CPI inflation is on the decline, buy stocks.”
Now we’re actually facing the possibility of higher inflation in the near term. With a huge deficit and stimulus programs, TARP bailouts and massive government spending left and right, the expectation here is that we’ll be visited by inflation. If so, what can we do to protect our investments?
Go Beyond U.S. Stocks To Hedge Against Inflation
Don’t be 100% invested in U.S. stocks if that’s the case. Go beyond our domestic stock market for some protection. Some ideas include investing some of your funds in iBonds, TIPs, commodities and foreign equities. You can also invest in foreign currency through a bank like EverBank, which offers foreign currency products (particularly certificates of deposit).
It’s always a good idea to be diversified anyway — and it’s obvious why. As investors, we’re always facing different conditions brought about by changes to various aspects of the economy. Our portfolio may be right for one set of conditions, but may be unable to weather other economic and financial scenarios. It is therefore imperative for us to keep up with the signals put forth by economic indicators and perhaps to do what is necessary to build an all-weather investment portfolio.