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How inflation can affect your financial plan and where to invest? - Outside View by PersonalFN

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How inflation can affect your financial plan and where to invest?
Jun 24, 2013

As many of you may be aware, the WPI Inflation data for May 2013 came in 4.7%. But not very long ago, the inflation bug hovered over the +7.0% mark discomforting the Reserve Bank of India (RBI) and even we as citizens too.

You see, elevated inflation bug can be a devil, if you do not handle your finances prudently. So what is inflation? Well, to simply put, it refers to the rising cost of living through rise in the general level of prices. And the detrimental impact of high inflation is that it reduces the purchasing power of money and eats into your hard earned savings. You may have witnessed that today, with Rs 100 in your pocket you can buy fewer goods and services than you could, probably about a decade ago. That is because the value of your hard earned money and savings does not remain constant; it reduces as the inflation bug eats into your hard money and even what you have saved. So, day after day, your savings may lose their worth, making them incapable of attaining your financial goals. Therefore it is important to keep a watch on your finances no matter how much you earn, because inflation can be a devil and erode the purchasing power of your money. It is noteworthy that inflation has a bearing on all your life goals, and thus it is imperative to consider its impact while planning for your future.

Let us understand with help of an illustration...

Mrs Shah has a 6 year old son. She wishes to send him to a good college for graduation when he turns 18. Today, the cost for graduation is about 10 lakhs. Assuming inflation rate at 10% for education fees, the college fees would cost Rs. 31.40 lakhs after 10 years. That is the effect inflation has on expenses.

Inflation needs to be taken into account while planning for not only education but also retirement, holiday, wedding, medical or any other expenditure.

An overly conservative investor, who has not accounted for inflation while constructing his financial plans, might be the worst hit from its impact. This might be more applicable if he has been investing only in savings account or fixed deposit, which have failed to provide high inflation-adjusted returns. In such circumstances, although his monthly inflows remain fixed, the value of his hard earned savings and investments remain under question over the long-term. Depending upon the increase in the general price level, his personal and household expenses may rise, while his income level remains the same. And therefore, you see it is imperative to invest in asset classes well which can help you counter inflation better. But please do not disturb the asset allocation which best suits you taking into account your age, income, expenses & obligations towards debts, risk appetite and nearness to goal amongst host of other facets.

You see, there are certain asset classes such as Equities and Real Estate that enable you to fight the inflation bug over the long-term, but take into account the aforesaid facets as well while investing your hard earned money.

Equities over the long-term are one of the best to beat the inflation bug, as they can yield effective inflation-adjusted returns. To invest in equity, you could either opt for direct equity investment (i.e. through stocks) or invest through equity mutual funds. Both have their own pros and cons. If you as an investor have profound insights about stocks and investing, with the requisite time and skill to analyse companies, then you can surely begin independent stock-picking. But, in case if you lack any one or all these pre-requisites, then you will be better-off by investing in stocks through equity mutual funds, since they offer several important advantages over direct stock-picking, which are:

  • Superior diversification

  • Professional management

  • Economies of scale

  • Lower entry level

  • Liquidity

  • Innovative plans/ services for investors
But while investing in mutual funds too, care should be taken to select winning mutual funds, and prefer the diversified equity funds over sector / thematic funds.

Property is again a preferred avenue of investment as during inflationary times, property prices too tend to escalate in line with the increase in cost of construction. The only deterrent here is that the minimum amount you need to invest here is substantial and beyond the reach of most investors. Nonetheless, the past trend in prices suggest that investment in real estate or property has been quite rewarding, and can be considered by one as an "alternative investment" in your overall investment portfolio. However, while you invest in property, you ought to adopt caution and look into the following aspects amongst others:

  • Who is the builder?

  • What has been his track record?

  • Has he completed the construction of his projects as per schedule?

  • Visit the site and inspect the quality of construction

  • The rate which he is offering for the amenities offered

  • What would be the approximate maintenance cost?

  • The development in the surrounding area where you intend to invest

  • Title of the property on which the construction is or has taken place (to ensure that it free from any encumbrances and litigation)

  • Has he obtained all statutory permissions

  • In case of a ready property - i.e. newly constructed or a resale property, has a society being formed

  • Is the builder listed or recognised by the housing finance company (in case if you want to avail a home loan facility)
It is noteworthy that India offers a huge growth potential in the infrastructure space, and thus given that if one lets out the property on rent, appealing rental yields could also obtained, apart from capital appreciation over a period of time.

Inflation-indexed bonds (IIBs) are also a good option if one is risk averse. IIBs are debt instruments which endeavour to offer return higher than the inflation rate (or to simply put, the rising cost of living which eats into our hard earned savings) if held till maturity. These bonds adjust the principal amount which one invests to the inflation, so that investors earn higher interest. You see in an inflationary scenario, where prices are on a rise and have an effect of eroding the value of hard earned savings, IIBs can work well for you. But during deflationary phase, they may not yield you much luring returns since them being linked to WPI inflation. Recently, on June 4, 2013 the central bank launched the first tranche of IIBs with a maturity of 10 years.

One can also look at investing in gold to counter inflation over the long-term as it has delivered luring returns over the long-term. You see when uncertainty has afflicted global markets; the precious yellow metal has done well as smart investors take refuge under it in times of uncertainty. But it is noteworthy that gold generally tends to perform inversely vis-a-vis equities in times of risk-on and risk-offs. While investing in gold you can either buy physical gold or invest in Gold Exchange Traded Funds (GETFs) or gold savings funds. But we recommend that you invest in the precious yellow metal the smart way and that is through GETFs for the host of advantages it has to offer. Alternatively, gold savings funds (which invest in GETFs) can also be considered if you want to invest regularly in gold, as such funds offer you the Systematic Investment Plan (SIP) mode of investing , which provide you with the benefit of rupee-cost averaging and compounding.

So having a combination of investment instruments (such as the ones mentioned above) giving due respect to your asset allocation can add as a portfolio diversifier which can help you reduce investment specific risk and combat inflation bug.

The impact of inflation must be taken into account while investing in all financial instruments. It is important to check the 'real rate of return' (also known as the inflation-adjusted returns) before investing.

PersonalFN is of the view that even though the WPI inflation has been comparatively low in recent times, you should not be complacent while constructing your financial plans. Any decline in the inflation rate cannot be construed as a reason for extra expenditure.

It is very important to keep in mind a realistic inflation rate while constructing financial plans for the long term. Further, efficient asset allocation enables us to mitigate risk. There is also a need to review your plans to ensure that they are in line to benefit from the current market conditions so as to achieve your financial goals.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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