The deflationary power of inflation

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   In India, over the last few years, the rate of rise in prices of several items, including consumables, has been in focus. Popularly known as 'rate of inflation', its sudden rise has been in focus among the policymakers, the government and the consumers alike. This is because it has been impacting each of these stakeholders in the economy in different ways.

   Of these three, however, consumers have been hit the most. And among the consumers, the policymakers and the people in the government, there is an overlapping category of people, the investors, who are being hurt badly by this inflation beast. But surprisingly, not many understand the scale of the damage inflation is capable of inflicting on their invested corpus when they look at it with a longer term view.

   A crude example would probably help here. In a very basic sense of the term, an annual rate of inflation of, say 8%, would mean that an article that cost you Rs 100 a year ago would cost Rs 108 today. Now suppose you, as an investor, had put in Rs 10,000 in a bank fixed deposit (FD) with an 8% interest rate about a year ago. Today, you have Rs 800 as interest income on that investment. But if the rate of inflation was 8% in the past one year, a basket of products and services that you would need regularly and which cost you Rs 10,000 a year ago would cost you Rs 10,800 today. So, even if you kept your money in a bank fixed deposit that earned you an 8% rate of interest, at the end of the year, because of inflation, you are still at the same level in terms of your purchasing capacity.

   You would actually be worse off if the rate of interest that you earned from the bank was lower than the rate of inflation. That is, suppose you earned interest at 8% or 9% and the rate of inflation was 10%, something that we all witnessed during the past several months. So, on a point-to-point basis, even though you saved over the last one year, in terms of your buying power you are actually worse off. Now juxtapose the impact of a 10%, 20% or a 30% rate of tax. If you are a taxpayer and face one of these three tax rates, you would be even more worse off. In such a situation, going by your tax rate, you would end up getting about 7%, 6.3% or 5.5% net return.

   Now to take this case a little farther: Think that you save every month some money, and you have done that over several years. But the rate of inflation makes you worse off every year (remember rate of interest in banks is closely linked to inflation). In that case, you could end up in a bad situation when you retire. So, what do you do now to save yourself from being affected by the inflation beast?

   Inflation leads to depreciation in the value of money. So, direct money investments do not take care of addressing this problem. The trick here is to aim for higher positive returns by investing in equities, equity-linked instruments and commodities, including precious metals. Over the long term, these will definitely beat inflation. The questions about how much you should be in equity, the ratio between equities and commodities, how much total investments should you do — all these are questions specific to each individual, and your financial planner and advisor should be able to guide you through this.

   The trick here is to aim for a post tax rate of return that would be higher than the rate of inflation. One of the tricks of achieving this is to invest in such instruments that, over the long term, they can give higher returns and also minimize the burden of tax on you.

   For any financial planning exercise, we always aim for positive returns. In India, the long-term rate of inflation has been about 6-7%. So, the aim for every financial plan should be to have an inflation-plus return, or at least the returns should match the rate of inflation, financial planners say.

   In India, since the general rate of interest in the economy is determined by the prevailing rate of inflation, the rate of interest you get in a bank FD is usually very close to the rate of inflation. For example, after the rate of inflation in India hovered above the double-digit mark, banking sector regulator Reserve Bank of India (RBI) also raised the key policy rates that determine the rate of interest in the economy, and FD rates also shot up to the current high rates of 9-10%. But here, the interest that you earn is taxable if you fall in the tax bracket.

   The same is the case for several other investment instruments like bonds, debentures and some of the small savings schemes. However, there is a particular type of FD, of five-year maturity, in which the returns enjoy a tax-free status.

   On the other hand, returns from equities, equity mutual funds and some other investment instruments, like the recently-introduced tax-free bonds, are tax free, provided these are held for the long term.

   Among the mutual funds, equity linked savings schemes (ELSS) allow you tax rebate while you invest and also on the returns from these schemes. In addition, among all the investment vehicles that allow you tax rebate under Section 80C of the Income Tax Act, these schemes have the shortest lock-in — of three years only. All others have 5,7,10 years of lock-in. The government, however, is thinking of reducing the lock-in for qualified bank FDs from five years to three years — at par with ELSS.

   Among mutual fund schemes, fixed maturity plans of more than one year are still attractive from the returns point of view, and also for their tax benefits, the latter coming from indexation. These instruments offer rates which are at least at par with bank FDs, but score over FDs in terms of tax advantages. All dividends and the redemption amount that you get from your long-term investments in mutual funds also are tax free. The same is the case for dividends you earn from your direct investments in equities.

Mutual funds also have the added advantage of diversification which also helps reduce your risks over the long term. Here, however, after the recent rally in the stock market, d iv i d e n d - yield stocks are not so attractive anymore.

   Markets have now gone up, and so calculations of one month ago do not apply in the dividend yield story anymore. If you are investing for the long term and directly in equities, one should look at the brick-and-mortar stocks.

Stocks of companies from sectors like FMCG, steel, automobile, cements, etc, are easier to understand than companies like software where a much larger number of factors influence the stock price. Among equities, historically it has been seen that stocks of companies with a solid business and a good track record have mostly beaten the rate of inflation over the long haul. Data show that over the past two decades, while the average rate of inflation was between 6-7%, the average rate of return in sensex was more than 15%.

 

 

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