How to Navigate a Low-Rate Environment

Stocks have performed well historically in an environment where prices are stable.

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Not so long ago, economists said we should be worried about the prospect of inflation. Now it's the threat of deflation that's making headlines.

The direction of the economy may lie somewhere in between. "Nothing is imminent," says Stacey Schreft, director of investment strategy at the Mutual Fund Store, an investment management firm. She believes that currently, deflation is "a little more of a concern" than inflation. Schreft sees the economy heading for a period of price stabilization in which neither inflation or deflation will be a major concern.

[See U.S. News's list of the 100 Best Mutual Funds for the Long Term and use our Mutual Fund Score to find the best investments for you.]

Many experts believe that inflation is no longer a major concern, so today's Federal Reserve announcement—that it will reinvest proceeds from other investments to buy long-term treasury bonds—shouldn't come as a huge surprise. The Fed has kept the target range for the federal funds rate (what the Fed charges banks to borrow money on a short-term basis) between zero and 0.25 percent since December 2008 and has repeated its pledge to keep rates low for an "extended period" since March 2009. In today's statement, the Fed also said "the pace of economic recovery is likely to be more modest in the near term than had been anticipated." The Fed added that it believes "inflation is likely to be subdued for some time." Without any signs of a clear pickup in the recovery, most experts say it will be at least another year before the Fed raises interest rates.

"I would still say no sooner than spring of 2011," says Jeff Tjornehoj, Lipper's research manager for the United States and Canada. "That's as far out as I could see the economy continuing to, I would say, coast along—not a very fast coast, but not one that's liable to double-dip or catch fire." Schreft thinks it will be at least another year before there are any changes in the Fed funds rate. With that in mind, here are some ways investors can prepare their portfolio for a slow economic recovery.

[See When Will the Fed Finally Raise Rates?]

Stay on the short end and diversify. With fears of deflation growing, John Diehl, senior vice president in the retirement division at financial services company The Hartford, says that because the yields of traditionally safe investments like money market accounts and treasuries are currently low, investors should make sure they also invest in a mix of high-quality securities like investment-grade bonds and U.S. treasuries, as well as some riskier assets like high-yield bonds and corporate bonds. "It may be worth it for you to look out on the credit spectrum," he says. "Because what you're really trying to do is get paid while you wait this out."

Just because the prospects are dim for rate hikes in the near future, you shouldn't stop thinking ahead. A year ago, many experts thought the Fed would raise rates in the second half of 2010. (Schreft admits that she did.) Many have changed their minds, given the slower-than-expected recovery. "I would still stay to the shorter end of duration and look to possibly pick up some yield in the meantime by looking at different credit risks or different types of asset classes," Diehl says. He believes it's important for investors to stick to short-term bond funds and diversify with fixed-income investments such as corporate bonds and treasuries. Diehl warns that when the economy does pick up steam, the environment can change very quickly, which means investors want to be well-diversified when rates finally go up.

[See When Choosing a Bond Fund, Keep These Factors in Mind.]

The case for stocks. Schreft and other experts say investors are overlooking stocks. "Stocks historically have tended to do well in periods of very low inflation and very low deflation," she says. Schreft is advising clients to avoid treasuries because of their low yields. She currently favors stocks, which investors have been avoiding for a number of reasons, including increased volatility in the markets because of the uncertainty of the recovery. "No matter what people are worried about, they want to get out of stocks," she says. Year-to-date through the end of July, investors have pulled almost $13 billion out of stock funds, while bond funds have seen inflows of more than $26 billion, according to Morningstar.