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Investment Strategy to Beat Inflation

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A penny saved is a penny earned, right? Not necessarily. Thanks to inflation, over time that penny could be worth less than when it was first dropped into the piggy bank. That's why if you're investing - especially for goals that are years away, such as retirement - you can't afford to ignore the corrosive effect rising prices can have on the value of your assets. Just what is inflation, this ravenous beast that eats away at the value of every rupee you earn? It is essentially the increase in the price of any good or service. The most commonly referenced measure of that increase is the consumer price index (CPI), which measures the consumer prices of a basket of commodities in different cities. There is another measure, the Wholesale Price Index (WPI) - This measures the different prices of a basket of commodities in the wholesale markets. The basket is broadly made up of Primary products, Fuel products, and manufactured products. Inflation has been a very consistent fact of life in the Indian economy. In recent times, India had managed to control this beast, and it was as low as 3% in 1999. But the start of the new millennium has seen this beast raise its ugly head once more. And slowly, inflation has crept up to 6%p.a, and is still rising. With the prices of fuel increasing, there is an across the board affect on all sectors of the economy. RBI's credit policy report also voiced concern over the inflation scenario, which they anticipate will cross 8% p.a. by the end of this fiscal.

So how does inflation affect your savings and investments? Take a look at this example-If you deposit Rs. 100000 @ 12% p.a., with the annual inflation rate being 5% in the economy, then the real return on your deposit is 12%(nominal rate) minus 5%(inflation rate), i.e.7% p.a.(real rate) This is because after one year when your deposit matures you will have to pay 5% more for any purchases owing to that being the rate of interest in the economy for a year. Also in today's economy, it's easy to overlook inflation when preparing for your financial future. An inflation rate of 4% might not seem to be worth a second thought - until you consider the impact it can have on the purchasing power of your money over the long term. For example, in just 20 years, 4% inflation annually would drive the value of a rupee down to Re 0.44, i.e-less than 50 paise or in other words half the present value.

So clearly, if you plan to achieve long-term financial goals - from college savings for your children to your own retirement - you'll need to create a portfolio of investments that will provide sufficient returns after factoring in the rate of inflation. So basically one has to look at a benchmark of return on investments which is higher than inflation so as to get a positive return on investments. So in times of high inflation it necessary to redesign ones portfolio strategy so as to include some inflation hedged investments. Finding good inflation hedges is tough. Traditionally a portfolio mix consists of (1)a low risk fixed income element, like-fixed income securities i.e- bank or company fixed deposits, bonds etc, (2)a medium to high risk speculative element which will yield capital appreciation i.e-equities, mutual funds etc.. Traditionally Gold and real estate have also formed a part of personal portfolios and do represent the best hedge against inflation. Gold can be held in the form of -mining shares, coins or jewelry. But Gold is struggling to regain its role as the world's most respected medium of exchange. It is engaged in this struggle with the U.S. dollar. As the dollar strengthens against all the world's currencies , gold has maintained its value against most other depreciating currencies, but lost value in dollar terms. Gold has become more expensive to buy in many societies that have traditionally hoarded it (Japan,China and India) even as it has under-performed in relation to the dollar. So perhaps gold is not such a good idea in India which has depreciating currency. However Gold's two advantages in the struggle against the dollar are, to us, critical ones: gold has intrinsic value (as jewelry and an element in manufacturing) separate and apart from its role as money, and it is a financial asset that is not someone else's liability. Real Estate is another major long term inflation hedger. But real estate as an investment carries the taboo of being very illiquid. The transactional costs of getting in and out of the deal are very high. Also the initial investment itself will be very high and one cannot correctly predict the appreciation. Also the real estate market in the dumps today and is expected to remain so in the coming year or two, the asset is rendered even more illiquid. However for people planning for the long term this would be a good inflation hedging avenue. Bulletproofing your portfolio against the threat of inflation might begin with a review of the investments most likely to provide returns that outpace inflation.

Over the long run - 10, 20, 30 years or more - stocks may provide the best potential for returns that exceed inflation. In India if we look at the cumulative annualized returns from 1980-96 then against an inflation of 9.34% gold gave a return of 9.51% Bank FD - 9.77% ,Company FD-14.40% and equities gave a return of 22.84%. "With regard to fixed income securities, any investment which yields less than 6%-7% should be avoided. This would automatically include, bank fixed deposits for less than six months, where the return is between 4.5-7%. The above one year deposits can be considered, where the rate varies from 9-10.5%,. But then the best option in case opting for long term investments of the fixed income yielding nature would be the PPF which gives a tax free 11% or the government's relief bonds which gives 9% tax free. Good company deposits also give between 13-15% for one year plus deposits, but then carry a higher risk as compared to bank fixed deposits. Bonds issued by financial institutions like ICICI, IDBI etc. offer a three to five year options between -10.5% to 11.5%p.a. The post tax return on these bonds better than company or bank fixed deposits as the indexation benefit is available to the investor. While past performance is no guarantee of future results, stocks have historically provided higher returns than other asset classes.

There are many ways to include stocks in your long-term plan in whatever proportion you decide is appropriate. You could create a diversified portfolio of shares from companies you select. Another option is a stock mutual fund, which offers the benefit of professional management. Stock mutual funds have demonstrated the same long-term growth potential as individual stocks. Especially with the equity markets down at the moment, this avenue offers a low investment, high liquidity inflation hedge. With infotech and pharma are the best bets for the coming years, one can invest in the sector dedicated mutual funds, with a time horizon of 2-5 years. Here again, like in the case of bonds the post tax return is better because of indexation and the long term capital gains tax which is at 20%.  Overseas investors have the choice of Inflation-Indexed Bonds which guarantee to offer a rate of return that is above the inflation rate. They protect principal from inflation by indexing principal to the Consumer Price Index, which is calculated by the U.S.Department of Labor. They protect interest from inflation by providing the investor with semiannual interest payments, based on the semiannual interest rate applied to the inflation-adjusted value of the principal. The drawbacks of the same are obviously that they may not keep pace with expenses (e.g.,college tuition) that increase faster than the inflation rate They could generate poor returns if inflation rate dips  In India we yet have to be offered options like this, but until then , it is necessary to inflation hedge your portfolio by having a diversified mix of debt, equity, precious metal and real estate. The percentage asset allocation can vary in times of high inflation towards higher yielding investments like equities and mutual funds and in case the markets do not merit investment and are on a downswing, then good old gold will come to the rescue.

Aru Srivastava

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