What is a worse scenario to face: your stocks falling price or everything costing you more? Or how about both? Last Saturday, I went to the supermarket and went into sticker shock. Everything that I normally buy had gone up in price: milk was up 30 cents, a cup of yogurt up 30 cents, salmon up $2. The U.S. consumer price index, which measures inflation, rose 4.3% last year; food and energy is, on average, 20 percent more than a year ago. A dollar doesn’t buy you what it use to. Of course, our stocks and mutual funds continue to fall in value due to the recession (only the politicians bury their head in the sand and say we are not in a recession).

The average investor is being crunched between a recession and inflationary pressures. The latter stupefies me; it is being fanned by the central banks desperately trying to avert a recession, which is already here, by lowering interest rates to stimulate demand when no one has any money to buy anything (remember we leverage ourselves to death using our homes as collateral?). This is become the most over-looked financial story of the year- the central banks are making the situation worse for political expediency.

What are we to do?

BUY GOLD?

Gold is traditionally seen as a hedge against inflation which is why it is being bid up by everybody. But here’s the problem with buying gold: GOLD IS AN INFLATION HEDGE (IF THAT) AND NOTHING ELSE. YOU GET NO APPRECIATION FROM GOLD ONCE YOU REMOVE INFLATION FROM ITS RETURN. Jerry Siegel authored a book entitled Stocks for the Long Run in which he looked at the real returns (returns after factoring in inflation) of certain investments from 1802 to 2006. If you bought $1 of gold in 1802, your dollar after inflation would be worth in 2006…$1.96. The same $1 invested in a stock would be worth $755,163 (includes reinvested dividend).

Gold would be an important part of a portfolio if you own other instruments which are not protected against inflation (i.e. the portfolio has a lot of principal protected notes in which the principal is not inflation protected- another strike against PPN’s or there are a lot of non-dividend yield stocks in the portfolio). The issue with buying too much gold is that one has forgone upside potential for short-term protective measures.

BUY REAL RETURN BONDS/TREASURY INFLATED-PROTECTED SECURITIES (TIPS)?

As the name implies, these are a type of bond that pays the holder a rate of interest which is adjusted to match inflation. TIPS are issued by the government and are seen as more “secure” than traditional bonds. The problem with TIPS is that, like gold, everyone is rushing to buy them increasing the price meaning that the yield on TIPS before taxes is now 0%. After tax, a TIPS would yield you a negative return.

The double whammy is if one bought a real return bond mutual fund (like me; another argument that I should just buy ETF’s and stop out-thinking myself). Not only is the yield now zero, the mutual fund company takes its fees off on top of that.

KEEP YOUR MONEY IN A HIGH-INTEREST ACCOUNT?

Not a bad idea but, in a falling interest rate environment, financial institutions are starting to lower the interest rate payable on these accounts so the return is diminishing. The disadvantage of this strategy is that interest is the highest form of income taxed so the longer money is parked in a high-interest account outside of a tax-shelter vehicle like a RSP or 401(k) the more money one is giving to the tax authorities.

PAY DOWN DEBT?

A good strategy in good, bad and indifferent times. This may be especially beneficial if one holds a variable rate mortgage and the interest rate keeps resetting downward to reflect falling interest rates. Under this scenario, a home-owner is paying off their mortgage faster. Low interest rate environments may also be a good time to consolidate debt into lower interest rate debt vehicles.

SAVE MONEY?

Buy a car which uses regular gas. Grow veggies in the garden. Buy in bulk. Shop at liquidation sales. Do anything and everything to pinch the pennies because inflation is making everything more expensive. Here is festival of frugality to help you with money saving tips.
BUY STOCKS?

I once got a good piece of advice about stocks which are falling in price- you either sell and lick your wounds or you keep buying at a lower price bringing the average price you acquired the stock down (known as “averaging down”). If one owns fundamentally good stock (dividend paying, health cash flows, expanding with an international presence), it may be an opportune time to look for a buying opportunity. It sounds counter-intuitive to buy while others are selling but, to paraphrase Buffet, you only want stock prices to be high when you are selling and not buying.

There isn’t one magic bullet solution to investing in hard times. The key is not to panic. Anyone else got suggestions?