Deflation Hurts, but Stock Returns Can Take It

Consumer prices fell more in October than in any one month in more than half a century, sparking new economic worries in an already shaky market. But while deflation drags down the prices of everything, including stocks, its impact on returns may not be as bad as you think.

There is little question deflation poses several economic challenges, including raising the cost of borrowing for individuals and businesses who are repaying debt -- with interest -- on items that are worth less than they were. Nevertheless, there's an inherent connection between stock returns and inflation that many investors with gloomy sentiment might be overlooking.

According to an analysis by Gerstein Fisher, an investment-advisory firm, during the boom time from 1970 through 2007, the typical balanced portfolio posted an inflation-adjusted return of 7%. That's because, despite double-digit stock performance of 12%, inflation remained stubbornly high, averaging 5%.

By contrast, during the Great Depression decade of the 1930s, which was characterized by massive deflation, unemployment and poverty, a similar inflation-adjusted portfolio gained 6%. Quality of life was undoubtedly better during the boom times, but because the Depression included an average -2% change in prices, and investment performance of 4%, returns were just slightly ahead in better times.

"The question we sought to answer," says Gregg S. Fisher, president and chief investment officer of the firm, "was, 'Is it possible that if you've got a $2 million retirement fund, and you're taking $100,000 a year, with 2% inflation, could it be equally good as with $2.5 million portfolio, taking $100,000 per year with 4% inflation?' And the answer was, 'Yes.'"