INFLATION: Bleeding us Slowly… Bleeding by Stealth…

Most risks surrounding our investments are fairly easy to understand to the extent that one can gauge the degree of harm they are capable of inflicting. However, there are some that operate in disguise; Inflation is one such risk. Omnipresent by its very nature, this risk rears its ugly head in almost every aspect of our lives that has anything to do with money or investments.

In this article, I make an attempt to shed some light on this “CRITICAL yet LITTLE CARED FOR” facet of our financial lives.

In simple terms, INFLATION can be defined as a sustained rise in the cost of living. Money tends to lose its purchasing power overtime leading to an escalation in the prices of goods and services. Inflation affects both basic living expenses and lifestyle expenses.

A look back: How things have shaped over the past few decades…

Amul Butter, one of our all-time favourite brands presents a classic example of how prices have been heading north at a breathtaking pace over the past four decades. From a little under Rs.7/- per 500 g to about Rs.225/- per 500g in a span of over 40 years sums up the whole story for the common man. A closer look at some of your favourite chocolate brands would reveal that their price would have far outdone their quality during this period. Not just these; everything from airline tickets to movie tickets, four wheelers to two wheelers, from your regular staples to lifestyle products; nothing has been left unscathed by this destructive force called Inflation; and of late, as for the way fuel prices have been racing ahead, the less said the better...

The official inflation figures won’t give you the complete picture as they represent only a basic set of products and services. In reality when we plan our finances, we need to account for something known as Lifestyle Inflation which presents a broader perspective by taking into account the minimum acceptable standard of living that we wish to settle for. Thus when planning for our goals, it would be prudent to take into account an inflation figure that captures to the extent possible, the true standard of our living.

The big question then is: How will the journey unfold in the decades ahead…?

While hindsight gives us the benefit of identifying a long term trend, forecasting is still risky business as there can be several variables impacting the outcome. I would therefore not wish to stick my neck out and make projections on the likely future inflationary trends in India. However, what I can do is make some reasonable assumptions based on historical data and a broad future outlook and extrapolate them to the future for the purpose of our computation. This may not be an absolute fool proof methodology; nevertheless it would lead us in the right direction.

I would prefer going conservative here and make a relatively higher estimate for inflation so as to have a good enough safety margin which ensures that my plans don’t derail even if my assumptions are a little off mark. Most experts on personal finance converge on an estimated figure of Inflation ranging from 5% p.a. to 7% p.a. for the purpose of planning our goals. So let me go with an average figure of 6% p.a. for our calculations.

Here’s how a 6% p.a. inflation will impact you over the years:

1. Impact on Living Expenses:
An Inflation figure of 6% p.a. means your expenses will double every 12 years. For e.g. If you are 36 years old and your present monthly expenditure is Rs.50,000/-, by the time you are 48, your monthly expenses will inflate to about Rs.1,00,000/- and by the time you retire at age 60, the figure would have ballooned to almost Rs.2,00,000/- p.m. In other words, it means that over the next 24 years, there is a possibility of your money losing its value to about 1/4th of what it is today. To simplify it further, the life style you enjoy today at a modest Rs.50,000/- p.m. will require four times this amount in 24 years i.e. Rs.2,00,000/- to fund the same lifestyle.

Now here’s a simple formula to compute the impact of inflation: FV = PV*(1+ R)^N
Where,
FV = Future Value (Inflation adjusted Future Expenses) – To be Determined
PV = Present Value (Present Monthly Expenses) – Rs.50,000/- p.m. in this case
R = Annual Inflation Rate (Assumed to be @ 6% p.a. in this case)
N = Number of years (Assumed to be 24 Years in this case)

Upon substituting the input values, we get the following result:
Monthly Exp. after 12 Years = Rs.1,00,610/- (approx. Rs.1,00,000/- i.e. double the amount)
Monthly Exp. after 24 Years = Rs.2,02,447/- (approx. Rs.2,00,000/- i.e. four times the amount)

2.Impact on Savings & Investments:
Money parked in financial instruments fetch us returns at a certain expected rate depending on the nature of the instrument and the time for which one remains invested. However the returns fetched need to be accounted for inflation to understand growth in real terms.

Here’s how we do it with the help of a simple formula:
Real Rate of Return = (1 + Nominal Rate) / (1 + Rate of Inflation) - 1

Where,
Real Rate of Return = Inflation Adjusted Rate (To be determined)
Nominal Rate = Rate of Return promised / estimated (without accounting for Inflation)
Rate of Inflation = Annual Inflation Rate (Assumed to be 6% p.a. in this case)

Using the above formula, let’s compute the Real Rate of Return for three of the most popular financial instruments availed by us: A Bank FD, A Debt MF & An Equity MF…

Real Rate of Return for an FD yielding 4.2% p.a. post tax return: -1.70% p.a.
Real Rate of Return for a Debt Fund yielding 6.5% p.a. post tax return: + 0.38% p.a.
Real Rate of Return for a pure Equity Fund yielding 9% p.a. post tax return: +2.83% p.a.

The above figures present three different scenarios expected out of the three instruments in consideration here. Of these, the Bank FD fails to beat inflation as is evident from the negative Real Rate of Returns generated, indicating capital erosion in the long run. As far as the Debt MF is concerned, it seems to beat inflation marginally and hence appears reasonably better placed than the Bank FD. However, with an impressive Real Rate of Return, it is the Equity MF that beats its other two counterparts hands down.

Thus among the three instruments in consideration, Equity MF seems to be the only one that has the potential to outpace inflation comfortably in the long run. Instruments such as Savings Bank FDs & RDs, Traditional Insurance (Endowment, Money Back) Plans used a Savings Vehicle, Annuity Plans, etc. are few of the examples of products that generate sub-optimal post-tax returns thereby leading to de-growth of your monetary assets in real terms over time. With Equity based products though, where volatility in inherent, a longer time frame serves as the perfect cushion to negotiate the rough and tumble of the markets, thereby enabling them to emerge stronger with time. Thus for long term goals, equity and equity linked products are by far your best bet.

However, one of the reasons we end up getting trapped in traditional low yield products is that many of them come camouflaged in assured returns; and who doesn’t like assurances? While liquidity, volatility, and fixed returns are important considerations to make in the short run, one must not get blind-sighted by the claims of these products being better placed to serve us well in the long run too. It is therefore time to shed our obsession with assurances and guarantees and look beyond them to understand the real worth of the financial instruments we subscribe to.

By no means do I intend to discredit any of the conventional products mentioned above… To the contrary I would say that some of these products do have their utility value albeit limited. However, the utility value of any product or its suitability may differ from individual to individual and can be gauged only after understanding the specific need for which the individual is availing the product, as well as the time horizon for which the individual intends to stay invested.

For instance, A Bank FD used as an avenue to accumulate for contingencies, isn’t necessarily a bad decision, especially if the individual concerned doesn’t fall in the taxable salary bracket. However, the same instrument, when seen from the perspective of an individual in the highest tax bracket, turns out to be an extremely poor choice. In fact when compared with FDs, Debt funds make a prudent choice in such cases, not just in term of returns, but also form a tax efficiency standpoint.

Conclusion:
The above illustrations show the damaging impact of inflation on our expenses as well as on our investments. They prove beyond doubt that Inflation is an evil lurking around waiting for us to take that wrong step. It is therefore critical to nip the problem in the bud. While there is very little one can do about the mounting expenses other than reducing consumption, choosing our investments wisely is very much within our control. Thus, financial instruments with the potential to beat inflation in the long run seem to be the only defence against this menace.

Let me also add here that some of the extrapolations and estimations you find in this article might appear a little far-fetched and disconnected from reality, especially when you think about them in the present. The only plausible explanation for this could be our shortsightedness; in matters related to money, we often fail to look beyond. However, one must realize that inflation has been hitting us hard all along and will continue to do so unless we choose to set things right. The slowness and steady pace coupled with the sheer stealth with which Inflation sneaks in, makes it all the more lethal; and by the time one realizes, it would have already dealt a bloody blow to our finances.

While our inherent Biases & Obsessions prove to be our biggest undoing when it comes to investments, it could at best, only partly explain, why we get drawn towards sub-optimal financial products time and again. Part of the reason also lies in our ignorance and our general lack of ability to assess the extent of ruin these products can cause in the long run, and take appropriate action where required.

Thus, while understanding Inflation might just be one of the several steps in planning our finances, our ability to account for it in our future estimates is what will make our financial plans realistic. Hope this article serves you to that end.

Time to Wake-up & Stem The Rot !!!