Inflation or Deflation: Which Economic Risk Is Greater?

(MoneyWatch)  There's a great debate about where the economy is headed, with Wall Street giants Morgan Stanley and Goldman Sachs standing on either side of the street. Goldman Sachs' chief economist Jan Hatzius is a pessimist, warning investors about the dangers of a global slowdown and the risks of Japanese-style deflation. Morgan Stanley's chief economist Richard Berner is more optimistic on the economy and more concerned about the risks of inflation caused by the loose monetary policy of the Federal Reserve.

Both men are highly intelligent, yet have diametrically opposed viewpoints. Which one should you believe? And should you base your investment strategy on the forecasts of economists?

First, most people believe the economist whose views confirm their own. This is known as confirmation bias.

Second, we've seen before how experts simply can't accurately predict the future on a consistent basis. Thus, there is no logical way for us to choose between the equally intelligent sounding forecasts of Hatzius or Berner (or any other economist). So what should you do?

The right way to address the problem is to figure out which is the greater risk to your overall portfolio: inflation or deflation. For example, retirees are generally more exposed to the risks of inflation than deflation. Thus, they should avoid long-term nominal bonds (though long-term TIPS would be perfectly appropriate). On the other hand, deflation is the greater risk for younger investors with stable jobs, wages likely to keep up with inflation and high equity allocations. (These investors should consider adding duration to their portfolios.) Deflation could lead to increased risk of job loss and negative impacts on their equity holdings. Longer-term bonds hedge those risks better than do short-term bonds. This issue is discussed in detail in Chapter Five of my new book, co-authored with Kevin Grogan and Tiya Lim, The Only Guide You'll Ever Need for the Right Financial Plan.