The hidden devil in your investment
Manu Kaushik March 3, 2010
Consider this: You invested Rs 2 lakh in a bank fixed deposit in December 2008 at an annual interest rate of 7 per cent. A year later, you got Rs 2,14,000 in hand. But that amount was just worth Rs 1,97,235 then! The bank didn't shrink your money. So, who did it?
The culprit here was inflation that had surreptitiously gnawed into your investments. Given that the rate of inflation for urban Indians (CPI-UNME) was at 15.5 per cent in December 2009, when it was subtracted from the 7 per cent rate of return that your investment earned from the bank, you got an effective return of minus 8.5 per cent. Little surprise that your investment had shrunk so substantially.
Now, if that is the toll inflation takes on your investment in one year, imagine what it can do to your savings over a longer period. In fact, it is estimated that a 6 per cent rate of inflation will simply halve the purchasing power of your money in 12 years. In other words, in 12 years it would take twice as much money to purchase the same goods and services as it would today. Says Hemant Rustagi, CEO, Wiseinvest Advisors: "Over the long haul, the risk of inflation to your investments outstrips all other risks, including capital risk." (see Experts' Take)
Yet, the irony is that most people exhibit an anachronistic behaviour when dealing with inflation. As consumers, most of us are acutely aware of the effects of price rise on our cost of living and even take appropriate steps to deal with the crisis. But as investors, we very often forget to align our investments with future consumption.
However, the recent roiling inflation should alert investors to factor in high inflation when planning for the future. Over the past year, the prices of foodgrains, pulses, vegetables and spices have more than doubled along with the cost of several services and education, forcing many whose incomes have not kept pace with the increase in prices to dip into their savings to meet key expenses. After retirement, savings will be the only income for most and, therefore, it's all the more important that they be hedged against inflation.
But what are the ways in which you can hedge your investments against inflation? A good investment protection for inflation implicitly cushions future consumption from price increases. The first step, then, is to determine the rate of inflation to be taken into account. Since the rate of inflation varies for different products and services and over different points in time, one needs to factor in different rates for different types of investments.
So, for instance, when planning for your child's education, you need to roughly figure out the increase in the cost of education and the time when you want it before working out the amount that would be needed. If a professional degree costs Rs 10 lakh today and if you assume that the cost of education will rise 8 per cent annually, then 12 years down the line the same course would cost over Rs 25 lakh. A faulty projection of inflation, on the other hand, can make your plans go awry. A 15-20 year life insurance policy with a Rs 1-2 lakh cover was popular in the '80s and early '90s. But at today's cost and standards of living, that amount won't feed a family for more than a few months if the insured person passes away.
Inflation planning also requires reviewing the inflation rate at least once a year and revising your rate estimates accordingly. "For both midand long-term goals consider the average of CPI and WPI and review once a year," says Ghosh. Once an inflation rate is factored in, the thumb rule is to ensure that you earn more than the current rate of inflation on your combined investment. That's because the real rate of return on your investment is what remains after subtracting the inflation rate from your rate of return.
A few insurance companies offer an indexation option to minimise the effect of inflation (see Insure Against Inflation). But there are some investments that have proven better than others in beating inflation, like stocks, gold and real estate; these are great for inflation-hedging but are also risky. "Over the long term, equity is a good hedge against inflation. Gold and real estate can be in your portfolio to neutralise the impact of inflation. But with debt-based (fixed return) investment one can be sure one will never beat inflation and may have a negative return," says Rustagi.
The Indian government has for long been toying with the idea of introducing inflation-indexed securities, which along with inflation-indexed annuities are popular in the developed markets. These options, when they come, will help investors fight inflation better. But most experts consider building an investment portfolio to be a safer bet.
Says Pallav Sinha, MD and CEO, Fullerton Securities and Wealth Advisors: "A well-planned portfolio, consisting of a child plan, retirement plan, equities and debt with proactive asset allocation approach can fetch decent ‘real' returns over a longer period of time." Within the portfolio, a good option is the age-based asset allocation model which is reviewed at regular intervals, taking into account various factors, including individual's age, inflation and risk tolerance. (See Portfolio as a Hedge.)
Investors have no option but to fight this many-headed monster and the best way to do it is to open several battle fronts by spreading their investments across asset classes.