Inflation and deflation, though opposite scenarios, are quite similar with regard to the havoc they can wreak on an investor's portfolio. One strategy for mitigating the negative effects of inflation and deflation is investing in blue-chip stocks, which historically are stable in value and have a track record of weathering both inflationary and deflationary cycles.

Inflation refers to a general increase in the prices of goods and services, making the same amount of money worth less. In moderate amounts, inflation is considered normal (2-3% per year being ideal) and can usually be outpaced by smart investing. The price of everything from cars to milk to a haircut slowly rises over time, but in a healthy economy, so do people's incomes and investment values. Inflation becomes a concern when it exceeds income growth and investment returns. In the United States during the 1970s, for example, inflation spiked as high as 13%, but wages were flat and the stock market was only returning 5-6%. As a result, consumers saw their purchasing power rapidly decline.

The defining characteristic of deflation, on the other hand, is declining prices. On the surface, it sounds like a good thing; as prices decline, the same amount of money can purchase more. However, deflation is often spurred by falling demand, usually resulting from underlying weakness in the economy. When prices begin to fall, consumers hold off on purchases, expecting prices to drop more. This lack of spending weakens the economy further, setting off a downward spiral that frequently culminates in a depression or a long period of economic stagnation.

Both scenarios create vexing situations for investors. Inflation puts conflicting pressures on stock markets. Rising prices have the potential to increase equity values; however, when prices increase, consumers' purchasing power decreases, and they buy less as a result. Companies' profits decline because they are selling fewer goods and services, which usually has a negative effect on stock prices. Even when returns are positive, real returns, calculated by subtracting inflation from actual returns, are usually negative during periods of high inflation.

Deflation almost invariably puts downward pressure on stock markets. Companies are forced to lay off workers and cut wages as falling prices cause revenues to dwindle; as a result, people have less money to invest or must liquidate existing investments to pay living expenses, causing stock prices to decline.

Blue-chip stocks are more insulated than others from these devastating effects of inflation and deflation. Blue chips are large, established companies, such as the ones that comprise the Dow Jones and the S&P 500. Most blue-chip companies sell products that are widely used in good economic times and bad, such as household goods, appliances and non-luxury automobiles. Even when their purchasing power decreases, people have to buy basic necessities, and that keeps these companies profitable. Many blue-chip companies, though not all, pay dividends. Dividends provide a much-needed additional income source when stock returns struggle to keep pace with inflation.

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  1. Deflation

    A general decline in prices, often caused by a reduction in the ...
  2. Inflation

    The rate at which the general level of prices for goods and services ...
  3. Purchasing Power

    The value of a currency expressed in terms of the amount of goods ...
  4. Price Inflation

    Price inflation is the increase in a collection of goods and ...
  5. Gross National Product (GNP) Deflator

    An economic metric that accounts for the effects of inflation ...
  6. Blue-Chip Index

    A blue-chip index seeks to track the performance of financially ...
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