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Why You Should Worry About Inflation?

Purchasing power is the number of goods or services that one unit of currency can purchase. It is literally, the power to purchase. For example, one rupee can purchase much less today than it could purchase say twenty years ago. If your money income stays the same, but the prices of goods or services increases, then the purchasing power of your income is reduced.

This increase in the price level of goods and services is called Inflation. So, your ‘real’ income refers to your income, adjusted for inflation. Thus inflation is the increase in prices that erodes the purchasing power of your money. And this is why inflation is the most important thing to account for when building your financial plan.

To see how inflation can burn the value of your money, simply see what happens if you invest in instruments that don’t match or beat inflation.

Let’s take a figure of Rs 10,000.

Assume an inflation rate of 10% and take a time period of 20 years.
In 20 years, you will need a figure of Rs 67,275 to have the same purchasing power as your Rs 10,000 today.

You have 3 choices of where to invest your Rs 10,000 today – the bank savings account, a debt mutual fund, and an equity mutual fund.

Let’s see how each one fares against an inflation rate of 10% over 20 years.

The amount you require to simply keep the purchasing power of your money constant is Rs 67,275. Inflation at 10% has eaten into the value of your money so much that over 20 years, even investing in a debt product at 7.50% p.a. post tax (such as a long term FD) is not enough. You need to earn at least 10% post tax every year to just match inflation and keep the purchasing power of your money intact.

In the table above, it is only equity earning 15% p.a. that matches and beats inflation. You can also match and beat inflation by investing into a mix of equity and debt instruments i.e. diversifying your investments across different asset classes.

So remember, inflation can and will eat into the purchasing power of your income. It is important to invest wisely so that your investments can beat the rate of inflation and you can achieve your life goals.

An asset allocation across equity and debt will help you to achieve your goals and also protect your investment corpus.

3 Ways to Beat Inflation

1. Look at Your Entire Portfolio One Piece at a Time, and Inflation-Proof it
   In each asset class, especially today thanks to the current high interest rate scenario, you need to choose investments that have beaten inflation consistently. If, in your fixed income portfolio, you invest in a corporate FDthat yields 8% p.a. post tax (considering indexation), you should note that the real return is actually closer to 2% per annum, after considering 6% inflation. 
   
   Include inflation hedged investments such as gold and if you can, real estate. Traditionally, a portfolio mix should consist of: 

1. Fixed income: low risk, safe yields, bank and corporate deposits, bond funds
2. Equities: high risk, high capital appreciation, mutual funds and direct equities
3. Pure Inflation Hedges: gold provides a low to medium risk inflation hedge that also offers a hedge against equity market volatility. In the sub-prime crisis, when equity markets fell, gold rose 30% due to the flight to safety. 

2. Bump Up Your Gold Exposure
   Typically, your invested portfolio weight should include 10% exposure to gold at all times. 
   Increasing gold exposure to this level is not easy to do in one step, so start an SIP or invest regularly into a gold ETF. But also keep in mind, that gold is not without its own risks. 
   
   Gold has two very strong qualities: it is a true financial asset i.e. it is not backed by paper money that governments can print at will, and it has a demand for use in jewellery and manufacturing. 
   
   People have also used real estate exposure to successfully hedge against inflation and in some cases, beat equity as well, but the real estate market is murky and difficult to advise on. 
    

3. Slowly and Steadily Continue Increasing Equity Exposure
   Historically, inflation has been in the range of 6-7%, while equities have given a return of 15-18% and even averaged above 20% per annum during the period 1980 to 1996. 
   
   While inflation will likely only go up from here, and equity returns are unlikely to stay that high, you can still expect that over the long term assuming inflation is 8% per annum and equities give a return of 12-15% p.a., your equity portfolio will beat inflation, delivering a healthy 4-7% post tax, post inflation, real return. 
   
   But remember that when including equity in your portfolio, whether by way of safe, less rewarding mutual funds or riskier, more rewarding direct equity, you must do so only in the proportion that your life goals indicate within your Financial Plan. 
   
   If you have less than 3 years to a life goal, your investments for this goal should avoid equity completely and be only in debt funds and other fixed income products. If you have more than 3-5 years left for a life goal, you can have some equity exposure and balance it out with debt and gold exposure.