The Debilitating effect of Inflation on Investments

This article was published in The May 2014 issue of the Global Analyst

       ·      Rs. 1 lakh invested in Equities 25 years ago will now be worth Rs.47 lakhs before inflation and Rs. 7.6 lakhs after inflation!
·         Rs. 1 Lakh invested in Gold 15 years ago will now be worth Rs. 6.7 lakhs before inflation and Rs. 2.7 lakhs after inflation!
·         Rs. 1 Lakh invested in Fixed Deposits 10 years ago will now be worth Rs. 2 lakhs before inflation and Rs. 1 lakh after inflation!
·         What Rs. 6,700 could buy in 1980, you will now need Rs.1 lakh for the same!

    Almost always we make investment decisions based on absolute performance rather than inflation adjusted performance. In my humble opinion, this approach can have very costly consequences in terms of our wealth and overall financial well-being.

     Without considering the effect of inflation, the investment performance can look really dramatic. For eg., Rs. 1 lakh invested in 1979 in equities can now be worth Rs. 1.88 crores!. But when adjusted for inflation it is worth only Rs. 12.6 lakhs, still better than other investments like gold and fixed deposits. Also, inflation creates more havoc in the long run than in the short run as it is a steady and silent killer. For eg., if you have invested Rs. 1 lakh in a fixed deposit in 1979, it is now worth Rs. 15.5 lakhs. But when adjusted for inflation, it is worth only Rs. 1 lakh! In other words, for 34 long years your investment worth has remained unchanged.

Source: RBI, BSE, and other sources. All data for period ending 31^st March 2013. 

     The table above reflects the complete picture across time and investment category. Let us analyse by investment category. At this stage, it may be worthwhile to explain what is nominal and real. Nominal rate of return is the absolute rate before adjusting it for inflation. Real rate of return is the performance after adjusting for inflation. For eg., during the last five years fixed deposits have returned an annualized return of 8% while inflation was also running at more or less same speed causing the real rate of return to be nil.

      

      Fixed Deposits

     If you are a fan of fixed deposits, think again. Most of us, deal with bank fixed deposits without realizing the meagre return (after inflation) that it offers. It has failed to produce any reasonable real rate of return in any time period. While banks have benefitted by the fixed deposits as they make nice spreads (the difference between lending rates and deposit rates), the investors have not made any returns since inflation eats away all the returns leaving nothing on the table. Whenever inflation increases in the economy, the RBI uses interest rates as a tool to contain the inflation (though I am not sure how effective that strategy is so far). In other words, when inflation increases, interest rates also increase thereby technically protecting the real rate of return. However, as data shows, inflation seems to have had the upper hand resulting in the dismal performance of fixed deposit. Over the long-run, a 0% real rate of return can hurt seriously. 

     

      Gold

    Your wife’s obsession with gold after all is not a bad idea! Gold has always produced good real rate of return across all time periods unlike fixed deposits. Gold seems to be having a gala time of late (during the last 5 years) compared to say last 25 years or 34 years. Gold has generated nearly 25% nominal returns annualized (before inflation) and 15% real return (after inflation) during the last five years making it as the best performing investment. It also had a nice run when seen from a ten year context with inflation adjusted annualized returns at nearly 11%. However, in the long run (25 years and 34 years), its real return (inflation adjusted) seems to be moderate but still better than fixed deposits.

    The recent good performance of gold in the last five years could be more due to global financial crisis and its aftermath all across the world. So long as global uncertainty persists, we can expect gold run to continue.

      Equities

      Indian Equities by far has the best story to narrate, especially in the medium to the long-term. In the short-term, (last 5 years), the equity performance is negative after adjusting for inflation but this is only expected given the volatility with which this asset class evolves in the short term. As said before, the global financial crisis has a direct bearing on the performance of equities and hence it is no surprise that its performance has been lack lustre. However, if you can muster some patience, it is by far the best hedge against inflation. It produced a real return of 8.5% annualized in the last 25 years compared to 1.7% for gold and 0.9% for fixed deposits. The same trend can be observed for the last 34 years where it produced a real return of 7.7% compared to 2.7% for gold and 0.1% for fixed deposits.

     It is thus clear that if we can have a time frame of 10 years+ then we can expect equities to protect us from the inflation beast. In the absence of treasury inflation protected securities (TIPS) as it exists in US, the only place to hide against inflation seems to be equities. Though there is no statistic to back the claim, I also feel Real estate doing a good job of protecting value against inflation.

      Welcome to the world of Finance!

     On a side note, while inflation is certainly not benefitting investors, it is benefiting insurance companies in terms of launching products. Recently Aviva launched “Family Income Builder” scheme which states as under:

    “You would be surprised to know that the cost of living has doubled in the last 12 years, and this trend is expected to continue. Are you sure that your savings are also growing at a similar pace? Presenting Aviva Family Income Builder - a life insurance plan that doubles your money. Pay an annual Premium for 12 years and get double of what you have paid every year, for the next 12 years, guaranteed”

    Simply put, what they are saying is that they will double your money in 12 years! A back of the envelop calculation says that the annualized return of such a proposition is just 6%, far lower than the fixed deposit returns that you get in banks! The catch is not in doubling, it’s how soon you double. Welcome to the world of finance!

   

     Trends and Challenges:

     There are 3 trends that are worth noting from a lifestyle point of view:

     ·        You will live longer than you think-more importantly your wife will live longer than you (based on life expectancy)
·         Your investment will produce lower returns as you age yielding lower income &
·         Your cost of living will increase more than what you estimate

      The power of inflation probably comes in directly in the last trend i.e., cost of living and to an extent in the second trend where after inflation the net returns will be lower. The final outcome of these 3 important trends is that you will experience a lower standard of living in retirement.

     

      How to beat it?

        ·         Focus on health-don’t just be content with maintenance. Spend money on building a healthier body.
·         Develop an investment strategy that is inflation proof (and fixed deposit is certainly not one of them)
·         Work longer-move your retirement age from 65 to say 70 or even 75

      The author thanks Karthik Ramesh and Rajesh Dheenathayalan for assistance.