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Soaring through the ceiling

Manu Kaushik     March 31, 2008

Why do we no longer see 50-paisa or 25-paisa coins even though these are still being minted by the Reserve Bank of India (RBI)? Blame it on inflation that has rendered these two denominations devoid of any buying power.

Nobody accepts them anymore, at least in the cities. Says V. Shunmugam, Chief Economist at the Multi Commodity Exchange (MCX) of India: “Inflation is not a new animal, it’s the same old genie in a new bottle.”

The inflation rate based on the Wholesale Price Index (WPI) has hit a 59-week high of 6.68 per cent for the week ended March 15 and households across the country are justified in fearing a rise in their monthly budgets. “Food items have become more expensive. Rising prices of primary food articles, like pulses, fruits and vegetables and spices, are expected to increase the burden on the common man,” says Shunmugam. Inflation can also spiral due to higher prices of oil and manufactured goods. However, higher food prices make the common man most conscious about inflation since he starts feeling the pinch on a daily basis.

But what doesn’t readily occur to the common man is the fact that inflation also eats into his savings and the returns on his investments. Let’s see how: suppose you invest Rs 100 for a year in a fixed deposit scheme that pays 10 per cent interest per annum.

At the end of the year, you will get Rs 110, out of which Rs 10 is the income from interest. But this is not your true gain, which has to be calculated by deducting the inflation rate from your income.

 Assuming that the inflation rate is at 6 per cent, your real rate of return will be only 4 per cent or, simply, Rs 4. Says Himanshu Kohli, Partner, Client Associates, a private wealth management firm: “The 10 per cent return that you get on your fixed deposit is the nominal rate of return. Once you deduct the inflation rate from this nominal rate, you get the real rate of return. And this is what should really matter to you as an investor.”

Where to invest?

Bank deposits aren’t the ideal long-term investments when you are planning for your child’s education and marriage, or your own retirement. Says Kohli: “Simple savings in your bank account are not going to solve this problem. As the rate of inflation is almost at par with the rate of return on your bank savings, one needs to look at other avenues that can beat inflation and help your money grow further in order to meet future requirements.”

These include equities, mutual funds, gold and property. If you are already invested in the above-mentioned asset classes, then now is the right time to churn your portfolio. Says Viraj Ghatlia, Head (Financial Planning & Wealth Advisory), ASK Wealth Advisors: “Managing asset allocations is an important part of combating inflation. Asset allocation is a long-term planning tool that helps derive a combination of assets that provide capital growth as well as regular income, which not only counter inflation risk but also help in achieving financial goals.”

Financial planners think that if you invest mainly in stocks, then you have less reason to worry about inflation. “When it comes to beating inflation, few asset classes can beat stocks. If you can follow your investments in the stock market, then you should invest in blue chip companies. Over the last three years, these stocks have returned in excess of 25 per cent, beating inflation, which averaged about 5-6 per cent during the period,” Ghatlia says, but warns that investing in stocks can be a risky proposition for many, especially if one is attempting to build his/her own portfolio of stocks.

“For those who want to minimise this risk, equity-based mutual funds are the best option. You can opt for systematic investment plans (SIPs) in equity-oriented mutual funds to meet long-term goals or, alternatively, look at investing in professionally-managed portfolio schemes,” says Ghatlia. Unfortunately, investors unknowingly are taking a much higher risk by not investing in equity instruments as they fear that inflation will erode their capital.

It’s hard to beat inflation with debt instruments. Says Kohli: “Debt products give returns in the range of 7-9 per cent. So, the real rate of return will be around 2-3 per cent, which is too nominal if one is, for instance, planning for retirement. But, of course, one can have 30 per cent of his/her portfolio concentrated in debt-oriented instruments.”

 Property is another preferred avenue of investment, as prices tend to rise in line with the increase in the cost of construction. But, Kohli says: “The only deterrent here is that the minimum amount you need to invest in property is huge and beyond the reach of most investors.”

Additionally, one can also look at investing in gold to hedge against inflation. Says Kohli: “In every portfolio, gold is a must, as it brings an element of diversification. The price of gold is driven by factors that are quite different from the drivers of other asset classes.” Wealth managers recommend investments in gold up to 10-12 per cent of the total portfolio. “Physical gold should be in the form of coins or bars.

Gold Exchange Traded Funds (ETFs), a relatively new concept, is another way to invest in gold. Since gold ETFs mimic the price of gold and offer higher liquidity, they are the ideal way to save for the future,” adds Kohli.

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