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Inflation effect: Are you getting enough returns? August 11, 2009
Want to do a reality check of your portfolio performance? In this article, we aim to understand the effects of inflation on your portfolio. We see how your portfolio gains should beat not just the benchmark but also the inflation rate so as to add sufficient value to your portfolio.
Author : Dhanashri Rane


Untitled Document

If you had been safely thinking that your investment is making good money for you, you are grossly mistaken. Why?

Inflation erodes the value of your money but before we analyse how inflation can impact your portfolio, let us first understand inflation well.

Understanding Inflation

Inflation is generally associated with increase in the supply of money. The surplus money available in the system causes the prices of goods to go up. That’s because more money is chasing the same set of goods. So, if you were buying a kilogram (kg) of onions at Rs.7.50 some time back, you may have to shell out more for the same. If you remember, in the late 90s, an incumbent government lost the elections in the state assembly owing to the extraneous rise in the prices of onions!

With high inflation, the value of each unit of money falls against the value of an asset. Due to excess liquidity and speculation, there is a compounding effect on the underlying value of an asset. Like in the previous example, onion prices had actually inflated to Rs. 60 per kg. Thus, the prices move away from their fundamental value and this creates an asset bubble. Once the bubble bursts, it can have a cascading effect on the economy as witnessed during the housing bubble burst in the US last year. Hence, the prices need to stabilise over a period of time.

While the prices spiral out of control, the wages need to be compensated accordingly. Simply put, the cost of living goes up. The government tries to maintain price levels by rationing (e.g., food items) and contain prices by fixing a ceiling price (e.g., kerosene, petrol prices). Since producers want to sell their goods at profitable levels, they lower or restrict supplies which ultimately drive or keep the prices up.

Impact On Investment Returns

Your money may be stashed away in a bank account or a fixed deposit to meet emergency needs or maybe because you are too apprehensive to invest. Definitely, a certain portion of your money is required to be set aside for contingencies. But if it is simply in your bank account, you are actually losing money every day. Unless the current return rate exceeds the prevailing rate of inflation, you are not really making any positive returns from the investment. Also, inflation impacts not just your portfolio performance but also how much you are likely to save in future, i.e., the money left after all expenses. As prices are high, there will be a higher expenditure and hence, less savings.

Let us see how the year-on-year increase in prices can affect your lifestyle.

Table 1 gives the data for Wholesale Price Index (WPI) and the Consumer Price Index (CPI). CPI captures changes over time in the general level of prices of goods and services whereas WPI has larger base of commodities. Chart 1 shows the WPI data over a period of 10 years averaging about 5.04%.

 

Source: iFAST Compliations

Annualised WPI (%)

Jul-08

Jul-09

WPI (All commodities)

12.13

-1.17

WPI - Primary Articles^

10.37

4.96

WPI - Food Articles

5.72

8.25

WPI - Manufactured Products+

10.99

-0.05

WPI - Essential Commodities*

6.31

10.6

Annualised CPI (%)

Jun-08

Jun-09

CPI - Industrial Workers# 

7.75

8.63

CPI - Urban Non-manual Employees#

6.76

9.68

CPI - Agricultural Labourers

8.77

11.52

CPI - Rural Labourers 

8.75

11.26

^Primary articles includes food items, oilseeds, fibres etc., 

+Manufactured products covers textiles, edible oils, iron & steel etc.,

#  May data 

Source: RBI

Inflation Makes You Poor

Since the CPI reflects the price level of consumer goods and services, we can assume an average of the CPI at a rate of 10.2725%. This implies that your cost of living has risen approximately by 10.2725% since last year. The items that you could fetch at Rs. 100 in the previous year, you may have to roughly pay up Rs. 110.2725 today

We try to find in the example given below how inflation can reduce the buying power of your money. The nominal value is plainly the value of the asset/ security when it is issued. Due to inflation, the nominal value has come down in one year to about Rs. 91 only.

Buying Power at the end of N years = Nominal value / Rate of inflation^N  

Buying Power at the end of one year = 100/1.10275^1 = 90.68

We estimate the present value of Rs. 100 at the time of your retirement i.e., after 20 years.Then, the buying power of this Rs. 100 falls down to meager Rs.14!

Hence, for a sum of money held over a period of time, the present value will fall each year. The premise is that the money is worth more today than in future.

Now let’s look at the impact of this on your portfolio. Suppose your portfolio has given you 10% returns.

When we say nominal interest rate, it is actually the interest rate available on a financial instrument. The nominal interest rate depends on the type of entity issuing the instrument e.g., bank or corporate, risk premium associated with the instrument and period of holding. Here, we assume that your overall portfolio is set to receive 10% returns post tax.

Real interest rate = [ (1 + nominal interest rate) / (1 + inflation rate) ] - 1 = (1.1/1.102725) = - 0.25%

- 0.25% is the actual return from your portfolio which is calculated to remove the impact of inflation.

In spite of a decent rate of return, you are earning negative on your portfolio in real terms. For long-term investment planning earning a negative return isn’t really exciting and helpful. Therefore, you should bear in mind the inflation risk and ensure that an adequate corpus is available at retirement. Your financial plans should maintain sufficiently high level of real return from the portfolio on a yearly basis. 

Beating Inflation With Right Assets

Considering equity or fixed income-based investments for your portfolio, we analyse the nominal and real return generated from the stock markets and GILT funds. Let’s aim to understand how each of the asset class can weather inflation better.

Chart 2 (Source: BSE Data)shows the BSE SENSEX performance adjusted for inflation.

The real returns from equity asset class were hampered due to inflation. However, equity continues perform well over long-term.

On close inspection, we notice that inflation does not have critical impact on the performance of the benchmark.

Despite the periodic jitters, equity as an asset class is less affected and can comfortably override inflation.

Chart 3 (Source: AMFI, iFAST Compilations)reflects the performance (real return) of GILT funds which is severely impacted due to inflation numbers. Throughout the period 2003 to 2009, we can see a consistent gap between the real and nominal returns of GILT funds. 

There are two major points of inflection (i.e., the bowl-shaped movements) in the chart.

The first one is around 2004 and the second is around 2008. The gap is most widely visible where the inflation has peaked to 8.74% around August 2004.

The next apex point is seen in August 2008 at 12.91%. Again, at this point, there is a significant difference between the real and nominal returns; even though the GILT funds display a healthy positive return of 7.87%, the real return is in fact -4.46%.

Conclusion

Our expenses amplify every year be it for household purposes, branded goods or tuition fees for children.  Considering the price index data for last several years (see Chart 1), a simple fixed return will not be sufficient to supersede the effect of inflation.

In a high growth economy like India, inflation is going to be a perpetual issue for the economy. Hence, you need to maintain an adequate hedge against price rise.

As quoted in an interview by the RBI governor, Dr. D. Subbarao, “We're an import-dependent economy that is reliant on importing commodities. So, import prices can drive up inflation. Capital flows could impact inflation. Decisions by other central banks could also cause inflation, especially in a globalising world.”  

Like any other asset, your money also depreciates unless you invest it.  In order to grow wealth over long-term and maintain purchasing power at retirement, investors need to ensure that they earn and save above the rate of inflation.

A fair amount of equity portion in your portfolio should help you maximise returns for future despite the short-term volatility in performance. Hence, for accumulating wealth, you can and should invest in equity funds and securities that can consistently beat inflation estimates.

STOP KEEPING MONEY IN THE SAFE, START INVESTING!

* Essential commodities (weight in WPI: 17.8 per cent) include rice, wheat, jowar, bajra, pulses, potatoes,onions, milk, fish-inland, mutton, chillies (dry), tea, coking coal, kerosene, atta, sugar, gur, salt, hydrogenated vanaspati, rape & mustard oil, coconut oil, groundnut oil, long cloth/sheeting, dhoties, sarees & voiles,household laundry soap and safety matches.


iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.

 


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