Inflation is a risk that was often ignored by investors until recently when retail inflation measured by CPI (Consumer Price Index) made headlines. Though the inflation levels eased to a four-month low at 5.3% in August, it is the 23rd consecutive month that has breached RBI’s target of 4%. Inflation essentially means your money tends to lose value with time. It devalues your currency.
Figure 1: Ministry of Statistics & Programme Implementation | Data as of July 2021
However, the real concern that this article aims to address is that inflation can also substantially reduce the ‘real’ return you get from your investments. Real return = return - inflation. For example, if you have parked your money in an FD, that increases in value by 5% each year, but inflation is 4%, the real return from that investment is just 1%. So, you can look for an option whose value can be tied to inflation. If inflation rises, its values may rise. Let’s look at a few assets:
Gold
Gold is a popular asset class whose value generally rise in tandem with inflation. A stronger currency keeps gold price lower, while a weaker currency makes the price higher. It can help investors to minimize the effect of inflation and currency debasement as generally, the gold price rises when the cost-of-living increases Though this year, the prices might have corrected significantly since 2020 levels, gold will continue to be a long term store of value. Moreover, Gold continues to be a good portfolio diversifier. It has a generally negative correlation with equities / other asset classes. Therefore, when the returns on equities or debt fall, the presence of Gold in the portfolio helps to minimizes the downside impact. Investors can consider options like Gold ETFs and Gold Fund of Funds that invest in Gold ETF to build their allocation to Gold.
Equity
Equity mutual funds have potential to provide risk adjusted long term returns.
Past performance may not be sustained in the future.
As you see in the table above, Gold prices have kept pace with the rising prices in a typical consumer basket over the last 30 years, whereas returns from equities have exceeded inflation rates. Equity mutual funds are more of a long- term investment option, at least a period exceeding 5 years.
Fixed Income:
Bond prices are inversely proportional to the movement of interest rates. When inflation rises, there is an expectation for interest rates to rise, leading to a fall in bond prices. So, in such circumstances, investing in short term and medium debt funds with a lower maturity period can be considered.
The key takeaway here is not to replace fixed deposits One must not concentrate all their investments into fixed income asset class that may diminish the real return and investors should diversify into equity, gold and other asset classes. Build a diversified portfolio catering across asset classes, market capitalization, sectors and avoid overconcentration to any specific asset or sector.
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