As someone once said, "Inflation is when you pay fifteen dollars for the ten dollar haircut you used to get for five dollars when you had hair."
But the dent inflation makes in your investments is far from humorous. In fact over the long-term the 'damage' is significant enough to make the most unflappable investor sit up and take notice.
First, let's understand inflation a little better. Simply speaking, an inflationary situation is where there is 'too much money chasing too few goods'. As products/services are scarce in relation to the money available in the hands of buyers, prices of the products/services rise to adjust for the larger quantum of money chasing them.
Let's understand this with the help of an example. Let's assume Rs 500 fetches you 1 gram of gold. Suppose there is a shortfall in the global supply of gold. The obvious implication is that gold prices will rise to adjust for the sustained demand at lower supply.
This may sound complicated but it's a thumb rule of demand-supply high demand combined with limited supply leads to higher prices. Let's say gold prices rise by 10%.
The revised rate of 1 gram of gold will be Rs 550. However, in real terms (i.e. in terms of the commodity in question) the value of the rupee would have declined from 1 gram of gold for Rs 500 to only 0.91 gram of gold for Rs 500.
So the value of the rupee has eroded. In other words, the same quantum has money now fetches you fewer goods. Now you know why that haircut does not cost the same as it did even 2 years ago!
Another important implication linked to inflation is higher interest rates. When prices in the system are in an upward spiral due to persistent demand, the central bank of the country aims to reduce demand in the economy by raising the cost of money.
You may want to know why we at Personalfn are raising the bogey of inflation at this point in time. We think this could be as good a time as any what with the Wholesale Price Index (WPI) breaching the 6% level.
In an interview with Personalfn, Rakesh Mohan, Deputy Governor, Reserve Bank of India, put things in perspective by stating that inflation was fuelled more by higher prices of commodities like steel and petroleum at the global level than by consumer goods like food products at the domestic level.
So it may appear that the inflationary situation we see today is more of a comment on the price spiral at the global level than the domestic level.
Nonetheless, the fact of the matter is whether you like/understand it or not, the danger posed by inflation is real and present and as an investor you have to take steps to safeguard your interests.
You not only need to be careful about future investments, you also need to review existing investments. In other words, you need to bring a fresh perspective to your investments.
Risk-averse investors who traditionally shun risk and embrace the safety of assured returns probably feel they are immune to inflation and its effects. However, nothing could be further from the truth. If there is one class of investor category who are completely exposed to the 'menace' of inflation it's the risk-averse, bond/fixed deposit investor.
As a matter of fact, the security and comfort associated with assured return schemes comes at a price -- inflation! Inflation eats into the returns offered by assured return schemes like fixed deposits and small savings schemes, thereby leaving investors with dismal real returns.
So how does the risk-averse investor counter this menace? There are 2 options at his disposal.
Short term deposits and funds
Typically, in inflationary times you should not lock your money in long-term bonds (like the RBI Bond for instance) and in fixed deposits with a longer tenure (over 1-year). This is because rising inflation is generally followed by rising interest rates as explained earlier.
Banks/institutions raise their deposit/coupon rates so investors who are already invested in these deposits/bonds witness what is known as an 'opportunity loss'.
However, fresh investors will clock a higher return on their deposits/bonds. So when there is even a likelihood of rates on deposits/bonds rising, choose short-term deposits. These investments will give you the required liquidity you need while ensuring that you do not lose out in case interest rates were to rise.
By the same logic, shun long-term debt funds. Inflation is a dampner on the price of longer maturity bonds. These bonds are the worst hit when the debt market is in the grip of an inflation frenzy.
Under inflationary conditions, bond prices fall and this pulls down the net asset values (NAVs) of bond/gsec funds. So existing investors see erosion in their debt fund NAVs. Again the way to counter this threat is to stick to short-term bond funds, which are relatively immune from the peril of inflation.
Capital-indexed bonds
These bonds compensate you for the rise in inflation (or the decline in the purchasing power of the currency). As yet they do not have a presence in the domestic debt market. The good news is that the Reserve Bank of India (in consultation with Government of India) proposes to introduce Capital Indexed Bonds in the country.
Key features of the proposed Capital Indexed Bonds:
Offer inflation-linked returns on both the coupon rate (interest rate offered by the instrument) and principal repayments as well. This would be achieved by adjusting the principal amount in tune with changing inflation rate.
Interest payments would be computed at a fixed rate on the adjusted principal amount. For e.g. say the bond is issued at Rs 100 on June 1, 2004 with a fixed coupon of 3.00%.
Six months henceforth when the first interest payment is due, the principal amount will be recalculated based on the existing inflation levels. The same CIB worth Rs 100 bond could now be worth Rs 110 on account of the rising prices, the coupon rate will be applied to this revised sum and interest payments made accordingly.
This is pretty much what the risk-averse investor has on his plate in inflationary times. On the other hand, the risk-taking investor has one more option to counter inflation equities.
Equities
It's no secret that no asset class evokes as much excitement as stocks/equities. However, in our view this excitement is often misplaced. Stocks stimulate unbridled enthusiasm and fervour for the wrong reasons. Investors take to stocks because of their ability to clock exponential growth over a shorter time frame.
For the serious, risk-taking investor stocks have a higher appeal -- their ability to effectively counter inflation and give superior real returns over the long-term vis-à-vis any other asset class. This is a fact attested to by several studies.
Busting inflation
The yawning void between inflation and investment in equities is evident from the above graph. Equally evident is the narrow gap between inflation and peer asset classes -- fixed deposits and gold.
However, stocks carry significant risk, especially if one is attempting to build his/her own portfolio of stocks. For those who wish to minimise this risk, diversified equity funds are an option.
In addition to the asset classes we have outlined, there are some other unconventional, but effective, investment avenues to outpace inflation. Commodities We do not suggest that they will most certainly do well, but in inflationary times, investors do find them holding up well against the sharply eroding currency value. Moreover, gold can now be deposited with institutions like the State Bank of India.
While this will earn you a very marginal interest, it will nevertheless take care of storage costs, etc. Investing in a commodity takes care of the risk arising due to erosion in value of the currency (since most currencies are priced in terms of US Dollars). Property If SEBI and AMFI have their way, this could become a reality in the Indian context.
So while inflation is a concern there is no need for you to be a sitting duck every time it rears its head. Fortunately for you, even an under-developed financial market like India offers you enough interesting and rewarding opportunities to make inflation seem like just another day at the office.
The key factors that determine the price of a commodity like gold for example (mine output for one) are different from factors that impact the value of other investments like shares and bonds. Investing in commodities therefore helps in diversifying the risk element in your portfolio.
Property is again a preferred investment avenue as in such times prices tend to rise upwards in line with the increase in cost of construction. The only deterrent here is that the minimum amount you need to invest here is substantial and beyond the reach of most investors. An alternative can be real estate mutual funds, which are quite popular in international markets.