Top Challenge for this Budget

All eyes will be on the Finance Minister as he presents the newly formed government’s first Union Budget tomorrow on 10th July, 2014. There are a host of challenges such as reviving growth, keeping fiscal deficit low, managing subsidies. However one of the major concerns for this budget is to bring down inflation.

With inflation being one of the biggest challenges of the economy, we share with you how inflation affects your investments and what you can do to tide over it.

Inflation is here to stay

Inflation, a phenomenon we encounter in our day-to-day life is nothing but the level of price rise in the goods and services we consume – from eatables to housing. Inflation is here to stay Inflation is not necessarily an evil; in fact growing economies would always have some measure of inflation. It is persistently high levels of inflation that can hurt. Central banks try to maintain inflation levels close to their economy’s inflation “tolerance” range which they work out after studying various economic factors.

The long term acceptable inflation rate for India’s economy is thought to be in the 4-6% range. In the past the average annual inflation rate as measured by WPI has been 6.7% for the 62 years between FY 1951 and FY 2013. The range shifted higher after the global financial market crisis of 2008 but it appears to be moving back to the acceptable level.

While we are more or less sure that inflation is here to stay we can make it work in our favour by managing our investments well. We can select investments made for long term goals with the aim of generating returns comfortably above inflation.

Inflation's effect on investments

Inflation erodes the purchasing power of money so that a given amount of money buys lesser goods than it would have earlier. A Rs 100 note that buys a burger today would not be sufficient to buy a burger next year. It would take more than that, depending on the inflation rate.

What inflation does to our investments is that it robs their real growth. This is better explained with how real return is calculated –

The technical formula for calculating inflation adjusted return is different* but the simple formula above works well enough for close estimates.

Thus if the return on your investment is 9% whereas inflation is 8% the actual return is merely 1%. Essentially what this means is that although every Rs 100 invested would have grown to Rs 109, owing to inflation the real value of it is only Rs 101 as inflation has reduced its purchasing power. Inflation can make goals much more expensive than what investments would allow to afford, unless returns from the investments are higher than inflation. Investors should bear inflation in mind while planning for long term goals.

Investing includes greater risk in the sense that there is a chance that there may be loss of principal. Stocks, mutual funds, bonds, real estate and gold are investment assets as they do not guarantee a fixed return, nor is the principal insured. Rather their values keep moving based on factors that affect their prospects.

As Indians we are traditionally wise savers. We save for long term goals like educating kids, social ceremonies and old-age financial security. However we are not savvy investors as we attempt to meet these long term goals while avoiding those products that are capable of meeting long term goals!

Gear your investments for inflation

We’ll discuss two time tested strategies that can help your investments be geared for battling inflation pressures. They have helped investors who adopted them keep calm and not worry much about meeting goals with their planned investments.

1. Have exposure to equities and gold

Equities, gold, real estate are assets whose returns are not fixed, rather they are free to move in response to factors and market expectations about their future prospects. Inflation is one such factor that affects the prospects of businesses (and therefore their stock prices), prices of real estate and gold.

Therefore it is crucial to have adequate allocation in equities and gold. The adequateness of allocation depends on factors such as your age, risk appetite, time horizon. This is explained in the article Asset Allocation ka Bulava.

Generally returns from equity and equity mutual funds have the potential to stay above the inflation rate in the long term period.

However it is alarming that the mass of Indian households avoids growth assets. The following chart shows that only 3% of the total financial assets owned by households are in equities. The rest are mainly in deposits, insurance products and pension funds, all of which are fixed income securities.

An investor whose savings & investments are totally limited to fixed return securities risks finding his investments to be insufficient to meet his long term goals in a scenario of high inflation. The risk of shortfall is more likely in goals with a very long time horizon, say 10 years or more. What could be the outcome in such scenarios? Either the goals would go unrealized fully or partially, or in case of unavoidable goals – like education, marriage of the child – investors might be faced with the unpleasant situation of having to borrow.

In fact the government has been trying to wean people from fixed income savings. RBI launched Inflation Indexed Bonds about a year ago offering interest that would be adjusted for WPI inflation every year. The Finance Ministry introduced tax saving RGESS in 2012 to encourage investment in shares and equity mutual funds by first time investors.

Sadly however these don’t seem to have motivated investors in a big way yet. “The best motivation” they say, “comes from within”, the reason why Quantum believes in imparting knowledge to investors through periodic mailers.

2. Plan, invest, stay long term

The next important strategy to follow for giving your investments the inflation edge is to have a long term outlook. Sure there would be those goals – typically consumption related ones – that are short term. These are the ones for which you would choose investments in products like savings deposit, liquid fund, short term FD, NSC, balanced funds etc depending on the time horizon. However for the rest of your goals build the discipline of investing in long term products, those that are capable of delivering returns that are reasonably above inflation... and staying invested until the end.

A lot of investors begin well by planning and investing in equity funds but fail as they get intimidated by market fluctuations. In fact talking about equities their very nature of moving with market conditions makes it necessary for investments in them to be long term. This is because in the short term markets react to news that may or may not affect their prospects however in the long term the valuations tend to correct themselves to reflect fundamentals more correctly.

Therefore resolve to add adequate exposure to growth assets in your portfolio, and to develop the discipline to keep long term investments exactly that – long term. Then you will have made inflation your friend and allowed investments to grow with it.

If you realize you are not adequately geared to tackle inflation why not take the first step today? Start an SIP in our flagship equity fund which is suitable for long term investments. At Quantum investments can be done online with zero paperwork. Call us on 1800-209-3863/1800-22-3863 or write to us about your interest or queries. Take the assistance of a financial advisor for your investment decisions.

*Inflation adjusted return = [(1+ actual return)/(1+inflation rate)] – 1

Source: RBI, Ministry of Statistics and Programme Implementation

Above article is authored by Quantum.

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