How to beat inflation

Though everyone knows what inflation is by now because it is the latest buzz, a quick guide as to what it means would only be apt.

Inflation reflects the rate at which the general prices of food and other commodities increase over a period of time. This ultimately leads to a decrease in purchasing power of money and that is what actually affects you and me. This means that what you can buy for Rs 10 today will cost you almost Rs 17 five years down the line for the same commodity considering inflation rate stays put at 11 per cent.

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The effect of inflation not only leads to hike in prices of commodities and food but also eats away into the returns on the investments of your hard earned money. This again hits you where it hurts the most, your pocket.

Though the nominal or stated rate of interest looks attractive what really the investor should be interested in is the real rate of return, that is, the inflation adjusted return. You need to know the real rate of return because that is what will allow you to check the true earning potential of the instrument as well as know the purchasing power of your investments.

Real rate of return is calculated as follows: Real rate of return (in percentage terms) = [{(1+ rate of return) / (1+ rate of inflation)} – 1] * 100.

Also, we cannot forget the tax component while calculating the real rate of return. Income tax, capital gains tax and all other taxes that you pay also eat up into the money that you earn as returns or profits. Hence, if we deduct tax (percentage is based on individual tax slab) from the returns and then calculate the real rate of return, the returns will go down even further.

With inflation reaching 11 per cent it should not come as a surprise to investors if the returns on their investments especially in debt instruments (like fixed deposits and debt income mutual funds) would be in the negative. This is even without deducting the tax component.

To really understand how inflation nibbles at your returns let us have a look at the table below. It calculates (using the formula above) returns that investors will get from various investment avenues like fixed deposits, NSC, PPF, post office returns etc.

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If we consider the recent inflation rate (11 per cent for simplifying calculations instead of the actual 11.05 per cent) in our formula above all investments, except those in diversified equity mutual funds and direct investment in shares, have turned negative.

In the above table the returns on debt and equity funds are on a ten-year average. The tax component has not been taken into consideration. If tax is taken into consideration the real rate of return will be further down on the negative chart.

I am sure the above table seems quite depressing. So the question remains: How to beat inflation? Well in this fight against inflation all is not lost. Not as yet. As clearly seen from the above table equities and equity linked products can help you beat inflation. However, it must always be kept in mind that in the short term both equities and equity linked products can turn risky.

Equities

This instrument though gives you sleepless nights due to the market risk involved but is one investment avenue which can beat inflation. This is true but only if you stay invested for the long term. Long term here could be safely assumed as staying invested for at least 8 years or more.

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As Warren Buffet, the richest man in the world and CEO and Chairman of Berkshire Hathaway says, 'Time is the friend of the wonderful company, the enemy of the mediocre.'

ou might wonder that in the above table how I took 15 per cent as returns on equity whereas in last few months the returns have been negative and in last few years the returns have been almost 30 per cent on an annualised basis. The 15 per cent return is an average you can expect to earn if stayed invested for long term, as volatility gets averaged out over the years generating good returns.

As can be seen from the above table the real rate of return by staying invested in equity for long term is 3.6 per cent, thus not diminishing the purchasing power of your investments.

Equity linked products (equity mutual funds)

The same is also true for equity funds. The best bet to select from equity funds would be diversified equity funds as the portfolio is well diversified among different sectors. Staying invested for long term is the key to earning good returns as well as beating inflation. Staying invested for long term averages out the volatility of the stock market and gives a steady return.

Gold

Recent years have seen lot of interest in gold. Why so? The biggest factor is the weakening of the US dollar. Universally, gold is inversely linked to the value of US dollar; hence with weakening of the US dollar demand for gold has increased. Gold has always been stated as a good hedge against inflation. It is considered as a store of value next only to the US greenback.

• The why and how of investing in gold

Gold is still a preferred medium of investment due to the fact that it the most liquid asset in the world. The market can meet the demand for gold as it is virtually indestructible and hence all the gold which has been mined till date still exists. Due to this liquidity and the depth of the market gold prices have more or less been stable besides a few ups and downs.

It is always recommended that at least five per cent of your portfolio must be invested in gold in the form of government certified gold coins or gold bars.

Gold exchange traded funds (ETF) is another good investment avenue. However, gold ETFs are fairly new in India. The first gold ETF was launched in February 2007. For investors who have storage problem and cannot buy gold lump sum gold ETFs are good avenues. But for gold ETF you will require demat and a brokerage account.

Although equities and equity linked investments are the only investment vehicle able to beat inflation only investing in them is also not advisable. Remember the old adage: Never put all your eggs in one basket.

The right combination of both the products -- equity and debt -- laced with gold investment is the best way to beat the demon of inflation in the long run.

Sheetal Jhaveri is a financial consultant and can be reached at dhanplanner@rediffmail.com