Have you ever thought why a samosa that costed ₹5 twenty years back, now costs ₹20? This is despite the fact that the ingredients and the taste of the samosa still remain more or less the same. Similarly, the prices of daily essentials such as grains, vegetables, fruits, petrol and diesel have also increased considerably over time. What has led to such price hikes although the nature and quality of these items has not changed considerably? Well, the answer to all of the above price hikes is inflation. Inflation is the underlying force behind these rising prices and the subsequent reduction in the purchasing power of money. This article will dive into the concept of inflation and how inflation can eat into your savings and investments and what you can do to beat inflation. Read on!
What is inflation?
Inflation is the persistent and gradual increase in the general level of prices of goods and services in an economy over time. As the prices of goods and services rise, the value of money decreases, meaning that each unit of currency can buy fewer goods and services than before. Inflation is a key macroeconomic indicator that influences the activities in an economy. It can have a significant impact on the entire economic ecosystem, including banks, policymakers and investment avenues, and can hamper individual investments. It is caused by various factors such as an increase in the money supply, rising production costs, and increased demand for goods and services.
Inflation decreases the purchasing power of money and results in increase in the prices of goods and services, making it difficult for people to maintain their standard of living over time. In the long run, this decreased value of money can further erode the purchasing power of savings and investments. For example, if the rate of inflation is higher than the rate of return on an investment, the real value of that investment will decline over time. This is because the returns on the investment will not keep pace with the rising prices of goods and services. Therefore, it is important to understand the concept and effects of inflation.
Why you shouldn't ignore inflation while making investment decisions?
Inflation gradually diminishes the value of money, eroding its purchasing power and ultimately reducing your savings. It is a significant threat to your investments, as it can disrupt financial planning and compromise your quality of life. Its impact permeates through the economy, influencing businesses, employment, consumer behavior, taxation, government policies and interest rates. Therefore, you must comprehend inflation's dynamics and its potential implications on your investments and returns. Failure to account for inflation can undermine your investment goals and expose you to unwarranted financial risks.
Inflation often operates silently in the background and its effects go unnoticed until it's too late to take action. Therefore, it is important to understand how inflation affects you. Inflation can impact you in two primary ways. Firstly, it can affect your spending as you would require more money to purchase the same products or services. Secondly, inflation can impact your investments, resulting in a lower return on your investments.
This is why it is important for you to consider the impact of inflation when making investment decisions and it is necessary to choose investment instruments that can offer returns that exceed the rate of inflation in order to maintain the purchasing power of savings and investments over the long term.
What is the “Real Rate of Return”?
The “real rate of return” is the return generated after taking inflation into account. The "real rate of return" is calculated by deducting inflation from the "nominal rate of return". It is important to consider the real rate of return, because it is the true measure of your investment's profitability, as it takes into account the impact of inflation on your investment's returns. If your investment's returns are greater than the rate of inflation, then it means that you earn a positive real rate of return on your investment. Conversely, if your investment returns are lower than inflation, it means that the real rate of return on your investments is negative.
Consider the following example to understand the concept of real rate of return and its importance for investors.
Let's say that the nominal rate of inflation is 5% p.a. This means that prices of goods and services are increasing by an average of 5% each year.
Now, let's assume that your investments in fixed deposits are giving you a return of 7% p.a. At first glance, it may seem like your investments are doing well, as they are generating a return of 7% while inflation is only 5%.
However, if you consider the after-tax rate of return (i.e., the rate of return after adjusting for the impact of taxes), you might find that the actual rate of return is 4.9% per year. This is because taxes can reduce the purchasing power of your investments.
So, even though your investments are generating 7% p.a. return, your real rate of return is negative 0.1% p.a. (i.e., 4.9% - 5% = 0.1%). This means that your investments not growing but actually depreciating.
This example clarifies the importance of real rate of inflation over the nominal rate of inflation. By focusing only on the nominal rate of inflation, you might overestimate the growth potential of your investments and fail to account for the impact of taxes on your returns. In contrast, by considering the real rate of inflation, you can get a more accurate picture of the true growth potential of your investments and make better-informed investment decisions.
Inflation affects the poor significantly
Inflation can have a disproportionately negative impact on people with lower incomes and fewer financial assets because they often have less ability to adjust their spending habits and investments to keep up with rising prices.
When inflation rises, the purchasing power of a fixed amount of money decreases over time, meaning that the same amount of money can buy fewer goods and services. This can be particularly challenging for people who rely on fixed incomes or have limited savings. Besides, their savings may be concentrated in low-risk investments such as fixed deposits that offer relatively low returns. If the interest rates on these investments fail to keep pace with inflation, the real value of their savings may erode over time. For example, retirees who live on a fixed pension may struggle to maintain their standard of living if the cost of goods and services they rely on increases faster than their income.
Effects of inflation on various investments:
Just as compounding works to increase your investment corpus, inflation works in the opposite direction by reducing the value of money and it is said that, "What compound interest builds up, inflation tears down”. It is therefore necessary to assess whether your investments are able to maintain your purchasing power. To achieve this, your investment returns must at least match the inflation rate. When the returns are higher than the inflation rate, purchasing power increases. Conversely, when returns are lower than inflation, purchasing power diminishes. Let us evaluate the effects that inflation can have on different types of investments you choose to make.
1. Guaranteed Return Investments:
There is an inverse relationship between inflation and interest rates and this makes guaranteed return investments particularly susceptible to impact of inflation. When inflation increases, investors expect higher returns to offset the loss of purchasing power caused by inflation. However, since interest rates on fixed income instruments are fixed for the term of the investment, the prices of these instruments decrease as investors sell them in favour of higher-yielding options. Consequently, in a scenario of rising inflation, fixed rate debt investments are at a greater risk of losses.
Let's take an example. Suppose you purchase a fixed-rate bond that promises to pay a 6% annual interest rate over a 10-year period. However, during this period, inflation starts to rise and hits 7%. As a result, you would demand higher returns to compensate for the eroding effects of inflation, and new bonds start to offer 7% interest rates. This makes the previously purchased 6% bond less attractive, causing its price to drop. If you sell the bond before it matures, you will receive less than what you had originally invested and effectively you would lose money due to inflation.
Therefore, if you prioritise the safety of capital and want to have the option of withdrawing the funds at any time, the investment returns are typically lower than inflation. This is true for all guaranteed return investments like fixed deposits, Public Provident Fund (PPF), bonds, etc.
In times of rising inflation, fixed rate debt investments are at a disadvantage as their prices fall due to investors seeking higher returns to beat inflation. Inflation Protected Securities, a category of bonds that adjust yields to inflation, could be considered during times of rising inflation. Floating rate bonds could also be a viable option in such times.
2. Equity investments:
The impact of inflation on equities can be either positive or negative and it depends on various factors such as the level and nature of inflation, external macroeconomic conditions, sector exposure of each company, pricing power and its balance sheet structure.
Generally, low to moderate inflation ranging from 2-6% is considered good for equities, while hyperinflation above 10-14% is bad. When raw material prices rise, it may impact a company's operating margins, but if the company has pricing power and can raise prices of its final products then it can maintain its margins while the consumer bears the brunt of inflation. The stock prices of such companies can increase.
However, if consumer demand is weak due to factors such as high unemployment, sector disruption, or other reasons, companies may struggle to pass on the increased cost of raw materials through their final product prices to the end consumer and their profits may decrease, leading to a negative impact on their stock prices.
3. Commodities:
Commodities, being physical assets, can be a powerful hedge against inflation as their prices are indicative of the underlying inflation. They act as an indicator of future inflation. Inflation is an index of weighted prices of various goods and services, such as raw materials (wholesale inflation) and final products (consumer inflation), which are combined in a basket. The proportion of these items is determined by government agencies in respective countries. Therefore, commodities such as basic resources, metals, energy and agricultural produce tend to perform well in a rising inflation scenario and vice versa.
4. Gold:
Gold being a physical asset is an effective hedge against inflation like other commodities. It is known as the best hedge against inflation, as it helps protect the value of your portfolio during times of rising inflation and therefore called "premium store of value". However, if central banks decide to raise interest rates due to inflationary pressures, non-yielding assets like gold may lose their attractiveness for certain investors.
Gold possesses several attributes that render it a valuable strategic asset in investment portfolios, such as its potential to generate returns over long-term periods, its low correlation with other asset classes, allowing it to act as a diversifier during both expansionary and recessionary periods, which can lead to better risk-adjusted returns. Gold is also highly liquid, similar to other mainstream financial assets and carries no credit risk. Additionally, investors view gold as an 'alternative currency' or 'currency of last resort,' particularly in nations where the local currency's value is depreciating.
5. Real Estate:
Real estate is also a physical asset that has a strong correlation with inflation. In times of rising inflation, property prices and rentals tend to increase as property owners and landlords demand higher returns to offset the increasing input and consumption costs. To gain exposure to this asset class, investing in Real Estate Investment Trusts (REITs) and Real Estate Exchange-Traded Funds (ETFs) can be a better option instead of investing in tangible physical properties such as land, residential, commercial, retail, or industrial properties.
How to deal with inflation?
From the above discussion, it is evident that investors can protect themselves from the impact of inflation by investing in assets that offer returns that exceed the rate of inflation. This may include investing in assets such as stocks, real estate, or commodities that are specifically designed to protect against inflation. Inflation is an unavoidable reality and therefore, the focus should be on creating an investment portfolio that can generate a high real rate of return. Such a portfolio would require you to include high-risk investments that have the potential to generate high returns over the long term, as well as conservative investments that provide capital protection.
Your portfolio should be designed with a focus on long-term objectives. Each financial goal carries different inflation rates, such as education, healthcare and recreation, which had inflation rates of 10%, 8%, and 10%, respectively, in 2021. To beat inflation, you need to have an aggressive portfolio, tailored to each of your financial goals. For instance, a moderate portfolio may suffice for a healthcare corpus for retirement, but a risky portfolio that is more equity-oriented may be necessary for an education goal. It is important to understand inflation from various angles and personal inflation is the best way to account for it. A portfolio that combines equity, debt and gold can help you fight higher-end inflation. At the same time, it is also essential to avoid undertaking unnecessary risk by investing more than required in riskier assets in order to beat inflation. Furthermore, rebalancing your portfolio periodically can also help to reduce concentration risk and beat inflation.
How to calculate personal inflation? Personal inflation is distinct from general inflation, which measures the overall price increase of goods and services, regardless of an individual's expenses. Personal inflation is tailored to one's unique expenses, which is why it is critical to consider when planning finances. For example, individuals and couples have different expenses and inflation affects them differently. Estimating personal inflation may seem daunting, but it is relatively simple. Start by listing all your expenses as a percentage of your total expenses. Then, visit the Reserve Bank of India's economy data portal, which provides detailed inflation data for various products and services, including CPI - Rural, Urban and Combined. Multiply the inflation rate with the corresponding expenses and sum up all the inflation-adjusted expenses as a percentage to determine your personal inflation. Remember that this value is unique to your expenses and using someone else's inflation rate may not be appropriate. |
Conclusion
Inflation is an inevitable reality that cannot be escaped. However, by understanding and accepting its existence, you can make informed investment decisions that help you earn higher returns. Failing to take into account the impact of inflation on your investments can have detrimental consequences. Inflation can erode the purchasing power of your money over time, which means you would need a higher amount of money to maintain your current standard of living. Without accounting for inflation when setting aside funds for long-term objectives, there is a risk of falling short of the required amount needed to achieve those goals. However, it is important to remember that inflation can be overcome by creating a well-diversified portfolio that considers long-term goals. This portfolio should include equity for growth and high returns, gold for value retention, and debt for stability and capital protection. Over time, such a portfolio would create wealth, but it's essential to review and rebalance it periodically, keeping in mind changes in personal and economic circumstances.
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