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• JUNE 11, 2011

# How does inflation affect your investment?

Suppose you have an option to either invest in a fixed deposit (currently yields about 8-9% pa) or in equity markets (have yielded average returns in the range of 12-15% over the last 10 years). Which investment avenue would you prefer? A rational risk averse investor would most likely opt for an investment in fixed deposit rather than equity markets. Investing in fixed deposit would not only provide capital protection but will also generate steady interest income for the investor.

Now let us add another rider here. Assume that the inflation rate prevailing in the economy is about 10%. Is the investor better off than before?

In order to answer this question, first one needs to understand the relationship between nominal interest rate, real interest rate and inflation. Going by the classic text book explanation the relationship between these three variables is defined as follows:-

(1+Nominal Interest Rate) = (1+Real Interest Rate)*(1+Inflation)

An approximation of the above formula gives us the following relationship:-

Nominal interest rate = Real interest rate + Inflation

It should be noted that the interest rate quoted on any particular investment is generally the "nominal interest rate". Hence, the interest rate quoted on your fixed deposit of 8-9% is the nominal interest rate. However, an investor should ideally be concerned about the real return on his investment as inflation typically reduces the purchasing power of any currency. Thus, any benefit gained from higher nominal interest rate (due to increased inflation) is virtually erased by the reduced purchasing power.

Let us explain it with the help of a simple example. Suppose you invest Rs 1,000 in a fixed deposit for one year with an interest rate of 8% pa. And the inflation rate prevailing in the economy is 10%. After a year, you would receive Rs 1,080 on your investment. But with inflation at 10%, your real rate of return is effectively negative.

Let's plug the figures in the above equation to show you the result.

8% (Nominal Rate, Given) = -2% (Real Rate, Plug figure) + 10% (Inflation, Given)

Hence, the effective benefit of interest earned on fixed deposit is completely wiped off. You might wonder - How?

Agreed, that you have Rs 1,080 from investment in fixed deposit. But with inflation ruling at 10% the price of a particular commodity basket which was Rs 1,000 earlier has now increased to Rs 1,100. Although your investment has grown by 8% the commodity prices have grown (at a faster pace) by 10%. So, even if you have Rs 1,080 from your investment you will have to shell out more (Rs 1,100) than what you have at your disposal to purchase the same commodity basket. This has effectively reduced your purchasing power. Thus, inflation has eaten away your real returns.

So, what could be the best source of investment in such an environment?

Apart from traditional bank fixed deposit the very next alternative that comes to an investor's mind is investment in stock markets. However, empirical evidence suggests that inflation and stock markets are negatively co-related. Higher inflation obstructs economic growth and thus stock prices. However, there are certain companies that are bound to perform better than others during inflationary periods.

For instance, companies with ability to pass on the inflation are better placed than those who are not. Passing inflation effectively enables the company to maintain its Return on Equity (RoE). Ability to sustain RoE's in an inflationary environment (where cost of capital is rising) enables the company to generate wealth for its shareholders (When RoE > Cost of Capital, economic profits would be positive). Such companies, when bought at attractive valuations, have a very strong chance of providing positive real rate of returns.

Thus, in an inflationary environment, an investor should ideally look at options that either generate positive real return for him or at least provide some natural hedge against inflation. Hence, the next time you place your money in fixed deposits; do check the headline of any leading daily to figure out the inflation number. May be, you have other better alternatives in hand.