How to avoid capital erosion arising out of inflation
How to avoid capital erosion arising out of inflation
Inflation never seems like a problem until suddenly it is. While it may be good news for borrowers, since it erodes the value of their debts, it can be damaging to savers, investors and pensioners, chipping away at the value of future interest and dividend payments and eroding the value of their capital. Once price rises become entrenched, consumers feel the pain, businesses become reluctant to invest and the stock market starts to get worried.
Steps to be taken for reduce the impact of inflation
There are steps investors can take, though, to lessen the impact of price rises and provide some protection to their assets as inflationary pressures pile up. The following are the certain investment and behavioural steps that the investors can follow.
Target equities with a global flavour
The only way to beat the incessant march of inflation is to invest in instruments that offer higher returns. Stocks and equity-oriented funds have a good long-term record of beating inflation. In the past 10 years, equity funds have delivered 12-15% returns, while equity-oriented balanced funds have given 10-12%. These investments are also very tax friendly, with no tax on long-term gains if the holding period exceeds one year. “The tax advantage that stocks and equity funds offer is low.
Another way of lowering the overall risk is investing via systematic investment plans or SIPs. The compounding impact of such investments over long periods will help you beat inflation by a comfortable margin.
Invest in dividend paying stocks
One good way of staying ahead of inflation is buying stocks that pay good dividends. Interest rate offered by banks is usually much less than the inflation rate.
Dividends are a tangible return paid by companies and keep up with inflation. Just like inflation, dividends, too, can be calculated annually. This figure, called the dividend yield, can be measured by adding dividends received during the year and dividing it by the stock price. The yield must be higher than the annual inflation rate.
Assets like gold and real estate
Gold is considered an ideal hedge against inflation. Market experts say real estate can also be an option if one can afford to spend a big sum. However, only a small part of your portfolio should be allocated to these options.
Inflation indexed bonds
These bonds are a great way to beat inflation as they are designed to protect both principal and interest. The basic mechanism of an IIB is quite easy to understand. Assume that the annual coupon, that is, the amount the investor receives at the end of the year on his bond investment, is 7%, and he has invested Rs 1,000 (his principal); in this case, he originally would have been paid Rs 70 at the end of the year. However, assume that the inflation index for the year is 10%. Through an IIB, the 7% coupon is then applied to the new principal of Rs 1,100 (10% of Rs 1,000 + Rs 1,000), which comes to Rs 77 plus Rs 100 increment on the principal. Thus, the investor is sure to generate a return higher than the inflation rate.
The principal is indexed to inflation and, hence, IIBs safeguard principal from inflation.
Invest in government-backed investment and deposit schemes
Government-backed investment schemes such as Post Office Savings Schemes, Public Provident Funds (PPF) and National Savings Certificates (NSC) are best to invest in when inflation is slowly inching up and you are only looking at safety, not returns.
Even bank fixed deposits are a good bet. These instruments also offer attractive rates of return. For instance, while post office schemes offer 8 to 9% guaranteed returns, the same can go up to 10-11% in the case of bank fixed deposits, which can’t be considered bad in the current scenario.
However, inflation eats into the returns offered by assured return schemes like fixed deposits and small savings schemes, thereby leaving investors with dismal real returns.
Asset allocation is critical. In this, one can look at an opportunity is to diversify globally. This will make your portfolio more stable and less vulnerable to domestic volatility and inflation.
Realign your portfolio
During periods of volatility and high inflation, it is imperative for an investor to reassess his/her asset allocation taking into consideration risk, times horizon and goals. At the same time, it is equally important for an investor to take a long-term view so that his reaction to developments in the market is not knee-jerk.
Curb your expenditure
Do not overuse daily essentials like cooking gas, electricity etc. Cut down on inessentials when buying groceries. Look for cheaper alternatives to products that you normally buy.
Follow a budget
Create a budget for monthly spending and savings. Save money at the beginning of the month and stick to your spending limits. Do not eat into your savings or debt amounts.
Invest as per your risk appetite
Investing long-term or short-term should all depend on your risk appetite. However, shorter the term, lesser the risk you should take with your funds. This will ensure that the uncertainty of returns is lesser as you gradually approach your financial goal!
Safeguard your investments
Invest in short term deposits and funds, commodities and property. This will help you to slowly reach your financial goals while safeguarding your hard-earned money.
Balance between safety & return
Should you put all your money into equities to beat inflation? No, say experts. Equity exposure should depend upon the individual’s risk appetite one should strike a balance between safety and returns by building a diversified portfolio.
“A mix of assets is ideal for reducing risk and optimising returns. When it comes to building a portfolio, there is no one answer. A call has to be taken based upon the individual’s needs, risk appetite, funds available, etc. For a retail investor, assuming that he invests only in equity mutual funds, proper allocation among categories such as large-cap, mid-cap and multi-cap funds is of vital importance
Always factor in inflation while planning for the long term
Inflation can be a real spoiler for your investment plans and goals, as is evident from the above examples. Although short term goals should also factor inflation, it becomes absolutely critical to consider it while doing long range planning. Therefore, if you are planning to take an international holiday after 10 years, which will cost you Rs. 5 lakh today, you must invest to achieve a corpus of Rs. 10 lakh, assuming an annual inflation of 7%. If you do not consider inflation, you would have planned for a corpus of only Rs. 5 lakh, and would be running Rs. 5 lakh short at the time of your intended vacation.
Keep a good mix of equity and capital protection
Equity investments are the best bet against inflation over the long term. It is recommended to invest in equity mutual funds in the form of systematic investment plans, to beat the volatility in the markets. However, putting all your funds in equity may not be advisable, as there is no guarantee for protecting your principal investment amount. Therefore, to strike a balance between risk and returns over the long term, invest a part of your funds in debt instruments, which can offer capital protection.
Keep an eye on inflation trends regularly
Investing and forgetting is the biggest mistake one can commit while planning money. If annual inflation is 5%, it may make sense to invest in a fixed deposit which gives a post-tax annual return of 8%. However, over the years if annual inflation creeps up to 9%, you will be earning negative returns on your investment. So, you should regularly review investments, and move to inflation-friendly products in a rising inflation scenario.
Make your insurance cover inflation-proof
Taking an adequate amount of insurance cover can help in meeting rising prices. When you determine the amount of insurance you need, remember to include all critical goals of your family, your liabilities and the amount of income replacement due to death. More importantly, when you calculate these amounts, do not forget to consider inflation.
Plan for retirement from an early age
Planning for retirement from an early age not only helps in giving you the benefit of compounding, but can also help in beating inflation. If you start investing Rs. 50,000 every year from the age of 25, you will be left with a corpus of Rs. 14.05 lakh when you are 60 years old (retirement age), assuming an annual interest of 10%. However, if you start with the same investment when you are 35 years old, you will have a corpus of only Rs. 5.4 lakh when you retire. If you start when you are 40, this will further fall to Rs. 3.36 lakhs. By starting early, the increase in retirement expenses due to inflation can also be met, as you have a larger corpus pool.
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