Overview on Inflation and Inflation Adjusted Return:
A commonly heard and used term of late, inflation is a malice that is plaguing economies across the world. Inflation is marked by spiraling prices resulting in shortfall of money to meet needs. Thus, money in hand would not be able to meet the purchasing cost and we would need to look out for alternatives to balance the budget. In such a scenario, the same product mix that we are purchasing today, would cost more once inflation sets in.
It is also caused by the increase of money circulating in the economy. As money in the economy increases, the prices increases leading to inflation. In this case, we would say that money has become cheaper, but this is driving the demand for products. Unfortunately, those products which are unable to meet demand become dearer and this leads to inflation.
Inflation and Demand
As inflation soars, demand for higher priced items falls and individuals look out for less expensive alternatives wherever possible. For instance, if you are using a particular brand of cooking oil, unless there are medical conditions that necessitate the usage, you would look out for alternatives that are affordable. Thus, the demand for Item ‘A’ would fall and be replaced by increased demand for item ‘B’ or ‘C’.
However, if the product is irreplaceable, cross elasticity of demand would come into play and while we would continue using Product ‘A’, we would make adjustments in purchases of some other products or product categories. For instance, a rise in prices of deodorants would not necessarily lead to fall in demand for deodorant, but there would be a parallel shift in demand for some other product like say soap, to compensate for the price variance.
Inflation and Purchasing power
Purchasing power is adversely affected by inflation. As it rises, money becomes dearer and money value decreases. This is just another way of saying that we can purchase fewer items for the same money. Many of us might have heard our parents or grandparents saying that they could have brought so much for this particular sum of money or that gold was only 1/10th the price it is today. These sentences are laymen speak for the time value of money caused by inflation. The soaring onion prices a few years ago or the tur dal prices that shot up in the recent past are classic examples of inflation and price rises affecting purchasing power. Individuals adopt interesting means to overcome the situation.
Below table illustrates the effect of inflation on few of the commodities over a period of 21 years:
Inflation and Investment portfolio
As illustrated in the above table, the cost of living has gone up in India over the last two decades and is further expected to rise, as India is one of the fastest developing economies. Hence, it is important from an investor’s point of view to have a portfolio that has a hedge against inflation. A balanced investment portfolio would consist of diversified instruments like Bonds, Gold ETFs, Mutual funds, Equity, Deposits and even Real estate. An ideal portfolio would be able to generate good returns and beat the inflation while being consistent in returns.
Investing in equities for a longer period is one of the best ways to beat inflation. This can be done by investing in mutual funds. There are various equity funds available ranging from large-cap, small/mid-cap to diversified funds. The compounding effect of such investments will help you to beat inflation over a longer duration.
I-bonds or inflation indexed bonds are a great way to stay ahead of inflation as they are designed to protect both your principal as well as interest. However, in India, they have not been successful because of their complex structure. They are linked to the Wholesale Price Index (WPI) which has been negative since Nov 2014 due to which the return on the bonds has been dipped and investors have not earned interest on these bonds.
Commodities & precious metals are a great investment option for beating inflation. Wondering why? It is simple. These commodities are the reason why inflation went northwards in the first case! Therefore, having assets like gold as a part of your portfolio makes sense.
While only a diversified portfolio can generate good profits, the investor needs to monitor regularly so that his portfolio has a hedge against inflation. A prudent investor need not refuse to take risks. Instead, he needs to evaluate risk and determine his risk appetite before making any investment decision.
Inflation Adjusted Return (Real rate of return)
The real rate of return is the return on your investment after adjusting for the rate of inflation. It is calculated by subtracting the inflation rate from the return on your investment. The Fisher equation provides the link between the return on your investment and the real rate of return.
Let r be the real rate of return, i be the return on your investment and π be the inflation rate, then the Fisher equation is:
1+i = (1+r)(1+π)
Let’s take few illustrations below to understand the concept of real rate of return:
1. Your bank pays a yearly interest of 8% on your fixed deposit and if the inflation rate is 10%, then the real rate of return on your fixed deposit using the above formula will be -1.8%.
In the above example: i= 8%, π= 10% and r= real rate of return.
Using the Fishers formula:
1+i = (1+r)(1+π)
r = -1.8%
2. You have invested in an equity mutual fund which is generating a yearly return of 12% and if the inflation rate is 10%, then the real rate of return on your investment after applying the above formula will be 1.8%.
Many investors tend to overlook the concept of inflation adjusted return (real rate of return). However, it is imperative from an investor’s point of view to know the inflation adjusted return (real rate of return) on their investments.
Inflation is a necessary evil especially in a developing economy like India and it eats up the purchasing power if not considered aptly. Therefore, it is crucial from an investor’s perspective to have a portfolio which is diversified and balanced, or we can simply say a portfolio that has a hedge against inflation.