For the uninitiated, inflation is the rate of increase in the prices of goods and services over a period of time. The increase in the supply of money put into circulation by global central banks during the pandemic to rescue economies from the covid-19 crisis has led to soaring costs, both globally and domestically.
While a moderate inflation rate is good for an economy, high levels are considered harmful.
At the individual level, higher inflation leaves less money for savings and discretionary spending after household spending. Moreover, it also has a negative impact on the returns of your investments.
And hence the phrase “inflation eats away at your returns”. This implies that the profits from your investments, despite decent returns, decrease if the costs also increase at a faster rate due to inflation.
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For example, suppose you plan to go on vacation next year and start saving each month to build a corpus of ₹1,000,000. Over the next year, if costs also increase at a faster rate than expected, you may have to shell out more money to enjoy the vacation you wanted, or you may have to make compromised on some of the experiments.
Thus, understanding inflation-adjusted returns, otherwise known as the real rate of return (RRR), is very important for effective financial planning. The real rate of return before adjusting for inflation is called the nominal rate of return (NMR). The real rate can be calculated by simply subtracting the inflation rate from the NMR.
We have looked at the real rate of return that asset classes such as equities (including international), debt, gold and real estate have generated in India in the short and long term.
Over the past year, all asset classes except gold generated a negative RRR as the rate of inflation exceeded investment returns (see chart). Gold, in terms of the rupee, could only generate a positive RRR due to the depreciation of the rupee; dollar gold generated a negative RRR as well as an NRR, calling into question its ability to hedge against inflation.
Over the long term, equities (including international equities) have obviously been the only asset class with a significant RRR. Real returns on debt (fixed deposits or FD) are only around 1-3% per year, indicating that it only protects capital. It may beat inflation slightly, but not significantly. Gold, despite bouts of intermittent outperformance, has lagged over the 10-year period with the lowest RRR of less than 1%. Residential real estate was the worst performer with a negative RRR over the 3-5 year period.
Equity: the winner
Stocks are a proven asset class that can beat inflation over the long term because companies have the ability to pass the costs on to their customers. Over the 5- and 10-year periods, the equity asset class represented by Nifty 50 generated real returns of 8-10%. “The pricing power exists with the suppliers of the products we use. When the costs of these products rise, it’s only natural that the source of inflation protection is likely to be equities,” said Vishal Dhawan, founder and CEO of Plan Ahead Wealth Advisors.
Within stocks, investors should focus on companies with higher earning potential, said Anish Teli, founder of QED Capital Advisors. “As long as earnings are growing, despite volatility, it will generate long-term returns,” he added.
Additionally, having exposure to international equities in the portfolio has gained traction in recent years and asset allocation without it is considered incomplete. According to historical return data, international stocks represented by the S&P 500 Index have outperformed both in terms of NRR and RRR. Kalpen Parekh, MD and CEO of DSP Mutual Fund, said he also classifies international stocks in the equity category. “Over a very long period of time, returns for global equities will eventually match those for Indian equities and vice versa. Due to some temporary cyclical factors, there are years when global stocks outperform Indian stocks and there are times when they look cheaper. I compare the two only to decide which one is relatively cheaper to invest. For example, now is a good time to invest in global equities, which corrected by 20-25%, while Indian equities remained flat,” Parekh added.
Debt: a stabilizer
We cannot expect meaningful returns outpacing inflation from the fixed income segment. As perihistoric data, actual DF returns have been only 1-3%.
“Whether or not you are getting an adequate real return on debt, your portfolio should have debt investments, which will allow you to take risk when investing in equities, which will actually generate higher RRRs. Debt provides portfolio stability during market turbulence,” said Ravi Saraogi, co-founder of Samasthiti Advisors.
According to Parekh, a 70/30 equity:debt portfolio, with periodic rebalancing to keep the weightings as is, will generate returns similar to equity but with volatility levels closer to debt.
One way to improve real debt yields is to invest in instruments with credit risk (other than G-secs and including corporate-issued debt), Dhawan said. It is a slightly high risk investment with a higher return potential than FDs
Gold: a diversifier
Gold has long been considered a hedge against inflation. But for many experts, gold is more of a diversifier than a hedging asset.
This precious metal, considered a safe haven in times of economic crisis, has a long market cycle compared to stocks, according to Samasthiti’s Saraogi. This is reflected in the 10-year return on the asset which was only 6.4%, with an even lower actual return at 1%.
“It’s an emergency asset class in a portfolio, and it performs very well when everything else fails due to its negative correlation to other assets,” Dhawan said. A 5-10% exposure to gold could bolster the portfolio during extreme volatility, experts say.
Real estate: low RRR
In India, real estate has been the preferred investment asset class for years. However, he was not a great performer. Over the 10-year period, according to the Reserve Bank of India’s All India House Price Index, the actual return on the asset was only 2.3% CAGR.
The index was calculated based on data received from housing registration authorities in 10 major cities (Ahmedabad, Bengaluru, Chennai, Delhi, Jaipur, Kanpur, Kochi, Kolkata, Lucknow and Mumbai).
“Rental yield in India hovers around 3% with little capital appreciation. If someone buys a property to make a huge profit, I think that’s wrong. That said, it is perfectly acceptable to buy a property for non-financial reasons. Life is not an Excel spreadsheet,” Saraogi said.
He further added that the argument for commercial real estate is different. “For people who want to invest in real estate, investing in REITS (real estate investment trusts) is a better alternative.”
Earning a negative real rate of return on investments can erode one’s long-term purchasing power. Paying attention to expected RRR and using estimates of future inflation can help you decide how much to save and how to make an appropriate asset allocation, giving due consideration to your risk appetite and the inherent volatility of each asset class. ‘assets.
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