Inflation isn’t in your control, so worry not

These days, a lot of opinions are being voiced on how high inflation is eating into your returns on investments, and how net-of-inflation return, particularly from debt investments, is negative. Those arguments have merit. However, there is a counter to that, too.

The fact that you have a disease and medicines are available does not mean you take the medicines — they should be appropriate for your symptoms and suitable for you.

How do you determine what is appropriate or suitable?

Investment objectives

The primary aspects on which your investment portfolio should be based are your investment objectives, financial goals, time horizon, risk appetite and the risk-return profile of the investments.

While your net-of-inflation real return ought to be positive, your portfolio allocation should not be distorted when inflation is high. As an illustration, if your appropriate portfolio allocation is 60% equity and 40% debt, it should not be 100% equity when inflation is high. If you have the risk appetite for 100% equity in your portfolio, it should have been 100% even when inflation was low. It is generally agreed that for retired senior citizens, equity allocation should be on the lower side. If that is distorted when inflation is high, it means going against the grain.

When inflation rate is high, the relevance for you is that prices of goods and services you consume are rising and that should be compensated for by your investments. If the return on investments (RoI) is lower than inflation, then at the end of the period, the worth of your principal will be less than earlier as it can help buy fewer goods and services than it could before. If your returns are higher than inflation, then it enhances value.

For example, if inflation is 5% and your RoI is 10%, you are well off. If your RoI is 5%, your investment is not making you any better off. Now, if your RoI is 5% and inflation is 6%, your principal is worth less than earlier. In such a situation, what should you do? Nothing much. If you increase the equity allocation in your portfolio just to beat inflation, it may not suit your risk profile. If you take lower-credit-rated, higher-yielding debt, it would raise the credit risk in your portfolio and that also may not be suitable.

Pace of rising prices

Inflation is the pace of rising prices. Of what? If you are basing the allocation in your investment portfolio on inflation, it should be on the basket of goods and services you consume. But that is not the case. The inflation data we see monthly, announced by the Centre, is the inflation for a given basket of goods across the country. But every individual’s lifestyle is different.

Consumption baskets vary across profession, age, location, gender, taste, preference and the like. Hence, the inflation number is at best an approximation of trends in the economy.

Then how would you know what part of the inflation number is relevant for you i.e. your consumption basket? Unfortunately, in a country of 138 crore people, it is not possible to measure as many unique inflation rates.

What does the consumer price inflation basket in India comprise? Almost half the basket constitutes food and food products.

While food is the major chunk of expenses for many people, it is not so for everybody, particularly in upper-income brackets.

Services are missing in the CPI basket, except for house rent and certain aspects of transport / communication. We consume services such as doctor consultation, dining at restaurants, haircuts at salons, app-based cab services, data/wi-fi, education/coaching, driver and domestic help. Net-net, if the headline inflation data for the month, as we see in the media, is say, 5%, then the inflation for your unique individual consumption basket may be, say 7% or even 3%, which is not evident to us. So, it may not be appropriate to build your investment portfolio based on a variable that may not apply to you. What does it all boil down to? The issue at hand is negative real returns in debt investments. Inflation is high, but does not typically remain as high forever. In 2020, CPI inflation averaged 6.6%.

The forecast for FY22 from the RBI, in the last policy review on June 4, was 5.1%. The projection can go wrong as there are certain pressures on inflation such as high crude oil prices, high metal prices, money circulation in the economy being higher than earlier or lockdown-induced supply constraints. These pressures could mean that even if inflation is higher than 5.1%, it could be lower than 6.6%. If you change your allocation, e.g. from debt to a more volatile asset class or high-yielding debt, you are reacting to something not in your control. Inflation and its measurement via a generic basket of goods is not in your control. Market movement, i.e. equity price levels or interest rate levels are not in your control. What is, is your investment portfolio. That should be based on proper, logical criteria about which you must be clear.

(The writer is a corporate trainer and author)

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Printable version | Sep 24, 2021 5:51:38 PM |

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