Who shrunk my savings?
Sudhir Gore and Narayan Krishnamurthy with Rajshree Kukreti
February 22, 2007
|"Indians do not account for inflation in financial planning, especially when setting their long-term goals."|
—Jayant Pai, VP, Parag Parikh Financial Advisory Services
"In the long-term debtbased (fixed return) investments will never beat inflation and may have a negative return."
—Gaurav Mashruwala, Financial Planner
|Click here to see infograph: Tagging it down|
Five faces of inflation
Worked up about the inflation rate topping 6%? Reality is worse than that. Here’s the full picture
Click here to see graphic: Five faces of inflation
You invested Rs 1 lakh in a bank fixed deposit in December 2005. At an annual interest rate of 6%, you were to get back Rs 1,06,000 in December 2006. Instead, what you got in hand after one year was only Rs 99,300. The effective interest rate on your deposit worked out to be -7%. Who shrunk your savings?
It wasn’t the bank. Banks can’t and won’t cut the interest rates. The culprit was somebody far more intractable and unstoppable: Inflation. In December 2006 the rate of inflation for urban Indians (CPI-UNME) was 6.9%. This means on an average, a rupee in December bought 6.9% less than it did a year ago. It also means that savings of Rs 1 lakh done in December 2005 was worth only Rs 93,300 in December of the next year Most of us know inflation raises the cost of living by raising the prices of products and services we consume.
Few of us realise that inflation also reduces the value of our investments. And fewer of us understand how to minimise the impact of inflation on our investments, and through that on our future consumption. After all today’s investment is tomorrow’s consumption. “Indians do not account for inflation in financial planning, especially for long-term goals,” says Jayant Pai, vice-president, Institutional Equity Sales, Parag Parikh Financial Advisory Services.
“People laugh when we talk to them about including inflation in their financial planning,” says financial planner Gaurav Mashruwala. That’s financial illiteracy. Because though you can’t prevent inflation and often can’t even predict it, you can surely protect yourself against it. But only when you do more than just gripe and blame the government for inflicting higher prices, and actually make inflation an integral input in your investment decisions.
Inflation and your investments
You can't stop inflation, but you can protect yourself against it by following a few thumb rules while making investments:
Make inflation the first input in your investment decisions At 6% inflation, a 8% fixed deposit will give only 2% real rate of interest—factor this in
Assume a realistic rate of inflation and review it at least once a year Benchmark investment with the right inflation index; err on the higher side
Keep in mind the changing consumption basket of your family Specific needs like education, transport, communications have different inflation rates
Fixed-income options, though safe, generally don’t beat inflation in the long term The longer your investment horizon, the smaller should be the proportion of fixedincome savings
Equity-linked investments have mostly risen faster than inflation rate The younger you are, a higher proportion of investment should go into equity-linked savings
Physical assets could also be a good hedge against inflation The value of gold and real estate generally rises when inflation is high.And so does your investment in these assets
There is no better time to start than now when policymakers from the prime minister downwards are worried about inflation. A look at your recent grocery bill will tell you why. By the Government’s own admission, prices of some foodgrains, pulses, vegetables and spices have risen by 20-75% in the past one year. Add to that a 40% hike in petrol prices (before the recent relief) and across the board increase in the cost of services (from mobile phone calls to couriers to carpenters)—courtesy the education cess and service tax.
This is the inflation as we officially know of. But there is more to it than what the government tells us. The official figures often underestimate the extent of the price rise— more because of inefficient data collection than a deliberate intent to suppress information. For instance, an ICICI Securities report shows that between February 2005 and August 2006, prices of cement rose by about 35%, whereas cement prices captured in the wholesale price index (WPI) show an increase of just 10% during the same period. Data gathered by Money Today shows an even wider divergence between the official and the actual price hike (see graphics Nailing the lie and Ground realities).
Not surprisingly, most households have not only been caught unawares by the sudden spike in prices but some fear a draw down on their past savings to meet their expenses. A few randomly chosen families from different age groups and states we spoke to expressed such concerns. None of them had factored inflation in choosing their investments, at least not consciously.
The consequence: the Dwivedis in Bhopal have had to downgrade the quality of rice they consume and don’t have much money left to invest for the future; the Dutts in Surat wonder how to fund their child’s education and have held back on plans to buy a house; and the Handas in Kanpur are combining their salary with interest income to meet household expenses.
Dissecting inflationA price index comprises thousands of products and services. Following are the key components of the consumer price index (CPI-UNME) and their inflation rate:
|Category||Weight in CPI (%)||Price rise|
|Cereal, pulses, vegetables, meals||22.6%||22-11%|
|Milk, milk products & oil||13.6%||6.2%|
|Transport & Communications||5.5%||4.2%|
|Fuel & Light||5.5%||5.9%|
|Recreation & Amusement||2.1%||5.3%|
|Price rise in December 2006 over December 2005. *Price rise in cereals was 11.4%, in pulses 21%.|
Only 75% of CPI-UNME basket is shown
Although no plan can be inflation-proof future earnings, the one based on a few basic rules can provide a reasonable protection. A good investment protection for inflation implicitly cushions future consumption from price increases.
What are the fundamentals of inflation planning? The first thing to decide on is what rate of inflation to take into account. There are five different inflation indices (see Five Faces of Inflation). They differ in the basket of products and services covered and weights given to different categories of products and services. The best known and most frequently updated index is the WPI. It is more relevant for producers and doesn’t adequately represent the household consumption basket. For urban Indians the most relevant index is Consumer Price Index for Urban Non-manual Employees (CPIUNME) which is released once a month (see Dissecting Inflation).
Similarly, there are indices for industrial workers, agricultural workers and rural labourers. So you have chosen the CPIUNME as your benchmark inflation index. The inflation data tells you the price rise in the past. For your investment decisions, you need an estimate of inflation in the future. A little search on the Internet, business publications or the Reserve Bank of India website will give you an idea of how inflation is likely to move in the next 3-6 months. But most investment decisions will involve long-term projections spanning several years or even decades.
Insurance, pension, child’s education and marriages, all require longterm price indexing. A wrong projection of inflation can make, say, life insurance worthless. A 15-20 year insurance policy with a Rs 1-2 lakh cover was popular in the 1980s 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, in case the insured person passes away.
Assume an inflation rate and revise it once a year. During high inflation, revisions could be once in three months. “For mid-term goals consider CPI-UNME with a halfyearly review. For long-term goals assign a higher value to inflation and review once a year,” says Pai.
A better approach is to break down inflation estimates for specific needs. So the inflation assumed for investing for children’s education will have to be different from the one assumed for saving for buying a car or a house. If you hope to send your children abroad for higher education, you have to make an intelligent guess of rupee’s movement against foreign currency as well.
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 to get ahead. That’s because the real rate of return on your investment is what remains after subtracting the inflation rate from your rate of return. There are investments that have proven to beat inflation better than others. Evidence from countries with mature stock markets and opinion of financial experts in India is that stocks and equity-based mutual funds give maximum returns over a period of time.
Physical assets such as real estate or gold are good protection too. Their prices generally appreciate in tandem with inflation. But investors with heavy or entire exposure to fixed investments could be the worst hit. “Over the longterm, equity is a good hedge against inflation. Gold and real estate can be in your portfolio to neutralise the impact of inflation. But with debtbased (fixed return) investment one can safely be sure that they will never beat inflation and may have a negative return,” says Mashruwala.
The fundamental lesson that inflation teaches us is: diversify investments, with a part committed in high reward but riskier instruments. Track them with one eye on the rate of return and the other on the inflation rate.
Sharad Dwivedi, 40
Media executive, Bhopal
Increase in income in the year:5%
Increase in household expenses: 20%
Spurt in food prices forced Dwivedis to downgrade the quality of rice they consume for the first time in their lives. He has cut his milk and fruit purchases. Investments? Only what is absolutely necessary to save income tax
Anil Dutt, 31
Sales executive, Surat
Increase in income in the past one year: 25%
Increase in expenses in the past one year: 20-25%
Inflation has eaten up almost all of Dutt’s increment. He is barely making his ends meet and saves only about 10% of his income. His child starts schooling in a year, and Dutt isn’t sure where the tuition fee will come from