In October 1972, petrol cost Rs 0.60 per litre. If you’d predicted then that it would cost Rs 70-plus in 2012, the average person would have called you a lunatic. Yet, let us suppose somebody joining the workforce in 1972 planned ahead to retirement in 2012.
In order to maintain a personal vehicle, he would have to afford petrol at Rs 70-plus. The 40-year rise from 60 paisa to Rs 70-plus equates to “just” 12-13 per cent per annum in terms of compounded inflation.
Most people have a mental block about the impact of inflation, and its mirror image, compound interest, over very long periods. This may be because most of us become aware of the value of money when we’re in our teens and 20s and we instinctively expect prices to stay at those levels.
But by the time we’re in our 50s and 60s, the cost of living will rise massively, even if the annual rate of inflation is not very high. Over very long periods, things get much more expensive. Since financial planning involves creating assets across decades, any successful strategy must take compounded inflation into account. You should decide on the lifestyle you want and allow for reasonable rates of inflation in calculating the income you will need 30-40 years down the line.
The RBI targets an inflation rate of 5 per cent based on the Wholesale Price Index (WPI). If the RBI consistently achieves its target, the purchasing power of the rupee will halve in 14-15 years. That is, you will need Rs 200 in 2026 to buy the same goods and services that Rs 100 can buy today.
In practice, the RBI has never achieved its targets consistently. Inflation has run at 7-8 per cent through the 21st century. Hence, the value of the rupee tends to halve roughly every 9-10 years. Let’s assume that this rate of 7-8 per cent will remain the long-term trend.
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Consider the implications. Suppose you stash a Rs 100 note under your bed in 2012, where it earns no interest. By 2042, it would buy no more than Rs 12-13 does in 2012. If you rolled that money over in a fixed deposit at 5 per cent compounded, it would be worth no more than Rs 43- Rs 44 in terms of 2012 purchasing power.
To beat inflation, your savings must generate a long-term return that beats inflation, or at the minimum, keeps pace with it. This is to ensure that you can at least maintain your current lifestyle decades later. If you want to improve your living standards, you must target a higher rate of compounded return.
This requires taking on some risk of capital loss. Safe instruments that preserve capital will not beat inflation in the long run. FDs and other forms of debt have a historical record of offering yields lower than prevailing inflation rates. Banks always keep an interest margin in their favour. They hike deposit rates with a lag when inflation rises, and cut rates quickly when inflation falls.
A bank fixed deposit (FD) currently offers 8 per cent yield or a little more. But that’s because inflation has been running higher – at well over 9 per cent - for the past two years.
The banks will cut their deposit rates the moment inflation goes down.
There are indeed brief periods when FD rates are favourable for investors. But this is only when interest rates fall during the tenure of the FD. In those circumstances, there are far higher returns available elsewhere.
For one thing, debt funds will bring capital gains when rates fall.
Since vanilla debt doesn’t beat inflation, the safety it provides is somewhat of an illusion. Debt instruments gradually erode in purchasing power. If you’re planning ahead for the long-term, you have to accept the risks that go hand-in-hand with higher returns.
Historically, equities have beaten inflation in the long run. But equities can also lose capital at alarming rates. Real estate is another potential winner. But there have been long periods when real estate prices have stagnated or even fallen. Also, if you’re buying real estate on a floating rate mortgage, the risks of debt-servicing can be tough to compute.
Sensible financial planning involves judiciously mixing risks with safety. Real estate, debt, equities have different risk:return profiles. You need some exposure to all three in order to look to the future with confidence.