Tuesday, July 7, 2009

Mutual Funds: Some Terms, Some TIPS, Some Bond Funds

Let's take a moment and clarify a few terms. Lately, investors and non-investors have heard some terminology being batted around, much of which all sounds the same. Inflation, deflation, hyperinflation, disinflation, stagflation. What do they mean and how do they ultimately effect your investments? Are TIPS the answer? Are bond funds protected?

We are all familiar with inflation. The term simply means that as long as your dollar stays in your pocket (or in the cookie jar or stuffed under the mattress) it is losing value. Often expressed as a percentage, it relates to the buying power of your money. In other words, if inflation is at 3% (for example) your dollar is actually worth less and when you eventually do decide to spend it, you will have to pony up an additional three cents to cover the costs.

Deflation is the opposite of inflation and much more troublesome. To be in deflationary environment is to see prices falling because there is no spending. Unemployment might be the cause. Tight credit might be the cause. Lack of government spending might also contribute. It has a spiraling downward effect that can be hard to change. Once folks stop spending, stop borrowing and basically hunker down, businesses react by layoff workers and producing less. Incomes shrink and the economy tanks. The Federal Reserve usually steps in making money available to borrow and increasing the supply of money available. Sometimes this is all that is needed; sometimes, as in the case of Japan in the nineties and through to 2006, it does not.

Disinflation is not to be confused with deflation. It is actually a good thing in many instances and can signal a reduction in inflation rates, which has the net effect of increasing the worth of the dollar in your pocket.

Hyperinflation is basically runaway inflation. The economy is out of balance. The country's currency has no real value and the balance between supply and demand is thrown out-of-whack.

Stagflation occurs when prices rise as manufacturers attempt to continue to profit but the job's market doesn't improve with those price increases. High prices and unemployment make for an unsavory pair and the result fo this often triggers inflation as well. When oil prices rise for instance but the economy has not provided enough jobs to absorb the increases, stagflation is often cited as the problem.

In tough economic times and with scary terms like the aforementioned get tossed around, investors look for some safety. Treasury Inflation Protected Securities are often where folks turn to cover their assets.

TIPS protect your principal and pay you a dividend (or coupon) every six months. That coupon is adjusted for inflation based on the Consumer Price Index or CPI. This is a survey of goods and their costs used to determine how much these items impact the average income.

And although this sounds like a good way to protect your money, the best way to do it is to buy those TIPS individually and not through a bond fund or ETF. Prices on these types of securities do change and you may lose money when you buy them in a fund.

Mutual funds will try to find bonds in which to invest. And while this is better achieved through a fund - they get better prices and are able to spread the risk among varying maturities - buying TIPS this way is not one of them.

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