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In last 10 yrs, CPI hovered around 8% annually while Sensex returns were nearly double at 15%
Inflation has become one of the most heard words in business and investment parlance. It has gained importance because it impacts salaries of earners, consumption, savings and investments of almost everyone, and returns on fixed deposits and other sources of income of the retired. So what is inflation? At the very basic level, it is the rate of rise in prices measured by some numbers, called index numbers, which have been standardized by the government.
To give a very simple example, without delving into index numbers, etc, suppose in May 2013 your total monthly household expenses on necessities was Rs 5,000. However, since the prices of most vegetables, fruits and other consumables have risen over the last one year, this May you end up spending Rs 5,500 on exactly the same quality and quantity of your basic necessities. So under this head your annual rate of inflation is 10%.
With a little observation, you can probably see the effect of inflation on your travel spends, expenses on child's education, medical facilities, holiday expenses, etc — things that are present more or less in everyone's life. Inflation also impacts your investments — an area which we will deal with here. Let's take an example to understand this.
Suppose in May 2013 you kept Rs 5,000 in a bank fixed deposit for one year at 9% rate of interest. This month, when that FD matures, you will get Rs 5,450. Now remember that to buy the same amount of household necessities this May, you are spending Rs 5,500 compared to Rs 5,000 a year ago. Again, suppose, to buy your household necessities you want to utilize the money that was kept in the FD. But then you will fall short by Rs 50 and may have to draw that extra amount from somewhere or, worse, reduce some quantities of food, vegetable or fruits that you buy. If this goes on year after year with the rate of return (here 9%) being less than the rate of inflation (10%), then every month you will need to draw higher amounts from somewhere, increasingly cut quantities or compromise on quality to meet your budget. The lesson here is that for the long haul, to maintain your standard of living, you should always target a rate of return from your investment that is higher than the rate of inflation. In the earlier example, if the FD rate was 11%, you would have been in a sweet spot.
According to data, the average annual rate of inflation in India measured by CPI over the last 10 years was about 8%, while the corresponding WPI number is less than that. So let us consider the higher of the two, that is the CPI rate.
Compared to this, during the same time horizon, the sensex has given an average annual retur n of about 15%, while FDs have given a retur n which is close to that of CPI. So if you had invested in an equity mutual fund scheme through an SIP and put in Rs 5,000 each month, and that fund had given you 15% as the annual average return (that is equal to that of the sensex), your current corpus would be Rs 13.76 lakh. Compared to that, if you had invested in something that gave you a return of 8% per annum, that is equal to the CPI rate, your corpus would be Rs 9.15 lakh.
So by investing in equity, which has historically beaten the inflation rate, you are better off by about Rs 4.50 lakh. If you can keep on investing in an investment product that beats inflation, over the years your gap with the inflation beast will only expand.
Of course, over the last 10 years, gold has given annual average returns of 16.7%, which is better than the sensex rate. But theoretically, gold is a hedge against inflation, so ideally it would give a return which will be just above the inflation rate, financial planners say. If you ask your financial adviser or planner, there is every possibility he/she will also suggest investing in equity to beat inflation, and that your exposure to gold should probably be 5-10% only.
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