Thursday, August 16, 2012

3 Ways to Beat Inflation's Inevitable Impact :

Have you ever thought of what a financial professional is doing when dispensing advice? He or she is basically taking an educated guess about what is going to happen in the future and suggesting a way in which you can take advantage of that future situation by taking action in the present. 

This involves making assumptions, and if something is based on assumptions, it can never be truly guaranteed. But there are some things, which despite the lack of a guarantee, are going to happen to everybody. And this article is about neither death nor taxes. 

Life is going to become more expensive. Your money's earning power is going to erode. Inflation is going to eat into the real value of your money. And you need to take steps to not just grow your wealth, but to grow your wealth continuously, and beat inflation by a wide margin every year. 

Let's start at the beginning and move quickly into the steps we need to take to beat inflation. 

Investopedia defines Inflation as: the rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling.

This means that if you're investing for goals that are years away such as y our kids' educations, marriages, and your own retirement, you will need a lot more money when these goals actually arrive, than you would need if they were happening today. 

The Government puts out 2 inflation figures every year, the Wholesale Price Index (WPI) and the Consumer Price Index (CPI). The CPI measures the consumer prices of a defined basket of commodities in different cities in India. Neither of these is the real level of inflation that affects you, the consumer. You can safely assume that the inflation level that you face is higher than even the higher of the two government released figures, that is the CPI. 

With the price of fuel increasing and the monsoon being weak, inflation this year and next is likely to be higher than last year. RBI's credit policy has also voiced concern over the inflation figure which is expected to cross 8% this financial year. 

So what do you need to do? 

1. Look at Your Entire Portfolio One Piece at a Time, and Inflation-Proof it

In each asset class, especially today thanks to the current high interest rate scenario, you need to choose investments that have beaten inflation consistently. If, in your fixed income portfolio, you invest in a corporate FD that yields 10% p.a. post tax (considering indexation), you should note that the real return is actually closer to 3% per annum, after considering 8% inflation. 

Include inflation hedged investments such as gold and if you can, real estate. Traditionally, a portfolio mix should consist of: 

  1. Fixed income: low risk, safe yields, bank and corporate deposits, bond funds
  2. Equities: high risk, high capital appreciation, mutual funds and direct equities
  3. Pure Inflation Hedges: gold provides a low to medium risk inflation hedge that also offers a hedge against equity market volatility. In the sub-prime crisis, when equity markets fell, gold rose 30% due to the flight to safety. 
2. Bump Up Your Gold Exposure

Typically, your invested portfolio weight should include 10% exposure to gold at all times. 
Increasing gold exposure to this level is not easy to do in one step, so start an SIP or invest regularly into a gold ETF. But also keep in mind, that gold is not without its own risks. 

Currently, the global situation for gold is negative. It is, in our opinion, temporarily struggling to maintain its position as a respected medium of exchange. As the US Dollar appreciates, gold loses value in dollar terms. However, for economies such as ours, that have traditionally been gold hoarders, local gold prices have gone up as our currencies have gone down in value. But in the long term, even after our currency regains value against the USD, gold will still have two very strong qualities: it is a true financial asset i.e. it is not backed by paper money that governments can print at will, and it has a use in jewellery and manufacturing. 

People have also used real estate exposure to successfully hedge against inflation and in some cases, beat equity as well, but the real estate market is murky and difficult to advise on. 

3. Slowly and Steadily Continue Increasing Equity Exposure

Historically, inflation has been in the range of 6-7%.
Historically, equities have given a return of 15-18% and even averaged above 20% per annum during the period 1980 to 1996. 

While inflation will likely only go up from here, and equity returns are unlikely to stay that high, you can still expect that over the long term assuming inflation is 8% per annum and equities give a return of 12-15% p.a., your equity portfolio will beat inflation, delivering a healthy 4-7% post tax, post inflation, real return. 

But remember that when including equity in your portfolio, whether by way of safe, less rewarding mutual funds or riskier, more rewarding direct equity, you must do so only in the proportion that your life goals indicate within your Financial Plan. 

If you have less than 3 years to a life goal, your investments for this goal should avoid equity completely and be only in debt funds and other fixed income products. If you have more than 3-5 years left for a life goal, you can have some equity exposure and balance it out with debt and gold exposure. 

To Wrap...

Official inflation measures such as the WPI and CPI are not accurate to your individual situation, the inflation you face is likely higher. If you take the above 3 steps, as soon as possible, and under the right professional guidance, you can and will likely beat inflation and achieve your life goals. Remember, time is money, and it's best not to delay these steps.
Source : personnalfn

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