How much will your monthly expense cost after a year due to inflation?

For the uninitiated, inflation is the rate of increase in prices of goods and services over a period of time. The increased supply of money put in circulation by global central banks during the pandemic to save economies from the covid-19 crisis has led to a spike in costs, both globally and domestically.

While a moderate inflation rate is good for an economy, elevated levels are considered harmful.

At an individual level, higher inflation leaves lower money for savings and discretionary spending after household expenses. Further, it also impacts the returns on your investments negatively.

And hence the phrase ‘inflation eats into your returns’. This implies that the benefits from your investments, despite earning decent returns, come down if the costs also increase at a faster rate due to inflation.

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For example, say you plan to go on a holiday next year and start saving every month to create a corpus of ₹1 lakh. In the next year, if the costs also go up at a faster rate than expected, you may have to shell out more money to enjoy the vacation you wanted, or you may have to compromise on a few of the experiences.

Thus, it is very important to understand inflation-adjusted returns, otherwise called the real rate of returns (RRR), for effective financial planning. The actual rate of return before adjusting for inflation is called the nominal rate of return (NMR). The real rate can be calculated by simply subtracting the inflation rate from the NMR.

We looked at the real rate of returns that asset classes such as equity (including international), debt, gold and real estate delivered in India in the short and long run.

In the last one year, all asset classes, except gold, delivered negative RRR as the inflation rate was higher than the investment returns (see table). Gold, in rupee terms, could generate positive RRR only due to depreciation in the rupee; gold in dollar terms delivered negative RRR as well as NRR, bringing into question its ability to hedge against inflation.

In the long run, equity (including international stocks) obviously has been the only asset class with meaningful RRR. The real returns from debt (fixed deposits, or FDs) are only in the range of 1-3 % per annum, indicating that it only protects the capital. It may beat inflation marginally but not significantly. Gold, despite bouts of intermittent outperformance, has been a laggard in the 10-year period with the least RRR of less than 1%. Residential real estate property has been the worst performer with negative RRR during the 3-5 year period.

Equity: the winner

Equity is s proven asset class that can beat inflation in the long run as companies have the ability to pass on the costs to their customers. In the 5-year and 10-year time frames, the equity asset class represented by Nifty 50 has delivered real returns of 8-10%. “The pricing power exists with the providers of the products we use. When the costs of these products go up, it’s only natural that the source of inflation protection is likely to be equities,” said Vishal Dhawan, founder & CEO of Plan Ahead Wealth Advisors.

Within equities, investors must focus on companies with higher earning potential, said Anish Teli, founder of QED Capital Advisors. “As long as the earnings are growing, despite volatility, it will generate returns in the long run”, he added.

Further, having an international equity exposure in the portfolio has gained traction in the last few years and an asset allocation without that is considered incomplete. As per the data on historical returns, international equity represented by S&P 500 Index has outperformed both in terms of NRR and RRR. Kalpen Parekh, MD & CEO at DSP Mutual Fund, said that he categorises international equity, too, under the equity bucket. “Over a very long period of time, global equity returns will end up matching that of Indian equities and vice-versa. Because of some temporary cyclical factors, there are years when global equities outperform Indian equities and there are times when it looks cheaper. I compare both of them only to decide which is relatively cheaper to invest. For example, now is a good time to invest in global equities, which have corrected 20-25%, while Indian equities remained flat,” Parekh added.

Debt: a stabilizer

We cannot expect significant inflation-beating returns from the fixed-income segment. As perhistorical data, real returns from FDs have been only 1-3%.

“Whether you’re making an adequate real return on debt or not, your portfolio must have debt investments, which will allow you to take risks when investing in equity, which will actually generate higher RRRs. Debt provides stability to the portfolio during market turbulence,” said Ravi Saraogi, co-founder of Samasthiti Advisors.

According to Parekh, a 70:30 equity: debt portfolio, with periodical rebalancing to retain the weights as is, will generate returns similar to equity but with volatility levels closer to debt.

One way to enhance real returns from debt is to invest in instruments with credit risk (other than G-secs and including debt instruments issued by companies), said Dhawan. This is a slightly high-risk investment with a higher return potential than FDs

Gold: a diversifier

Gold, for long, has been considered a hedge against inflation. But for many experts, gold is more of a diversifier than a hedging asset.

This precious metal, which is considered a safe haven during times of economic crisis has a long market cycle compared to equity, according to Saraogi from Samasthiti. That is reflected in the 10-year return from the asset which has been just 6.4%, with real return even lower at 1%.

“It is an emergency asset class in a portfolio, and behaves very well when everything else doesn’t because of its negative correlation with other assets,” said Dhawan. A 5-10% exposure to gold could provide some strength to the portfolio during extreme volatility, say experts.

Real estate: low RRR

In India, real estate has been the preferred asset class of investment for years. However, it has not been a great performer. In the 10-year period, as per the All India House Price Index of the Reserve Bank of India, the real return from the asset was just 2.3% CAGR.

The index has been calculated based on data received from the housing registration authorities in 10 major cities (Ahmedabad, Bengaluru, Chennai, Delhi, Jaipur, Kanpur, Kochi, Kolkata, Lucknow, and Mumbai).

“The rental yield in India hovers around 3% with not much capital appreciation. If someone is buying a property to make tremendous returns, I think, that is not right. Having said that, it’s absolutely fine to buy a property for non-financial reasons. Life is not an excel spreadsheet,” said Saraogi.

He further added that the argument for commercial real estate is different. “For people, who want to invest in real estate, investments in Reits (real estate investment trusts) is a better alternative.”

Conclusion

Earning a negative real rate of return on investments can erode one’s purchasing power in the long run. Paying attention to the expected RRR and using estimates of future inflation, can help you decide how much to save and how to make an appropriate asset allocation, with due consideration to one’s risk appetite and inherent volatility of each asset class.