Timing is crucial for debt investments with fixed returns.
The value of money is what it can buy by way of goods and services. That value changes constantly. In an economy with significant growth rates and high employment, it will tend to fall.
The reason is simple. Growth is generated by high demand. High employment makes it more difficult to satisfy that demand because there is less slack available to create more supply. However, productivity gains can occur from technological advance or better management practices.
Inflation can however, also be a sign of problems. When it is very difficult to create more supply, demand cannot be satisfied. Price will rise until demand drops and a new equilibrium is reached.
Inflation can also sometimes by tamed by raising interest rates. Rate hikes usually lag inflation itself because inflation must first be diagnosed before the rate hike can be implemented.
All this is obvious and basic. But it is also at the foundation of any systematic financial planning. If your investments don't beat inflation, your portfolio declines in value. It is difficult to beat inflation purely by relying on fixed income instruments because rates lag inflation.
It's difficult to track inflation, especially in an under-indexed economy like India. Government price statistics are collected with a lag and released with a further lag. The methodology of inflation calculation is opaque and flawed. There are multiple baskets with multiple weights.
There is a political incentive to officially understate inflation because voters and investors are sensitive about the subject. There is also political incentive to encourage inflation because it devalues the burden of previous government debt, issued at lower rates. As a result of this, it is prudent to assume that government statistics generally understate inflation.
Many if not most, investors are vulnerable to what is sometimes called the money illusion. The money illusion occurs when an investor conflates the real inflation-adjusted return, with the unadjusted nominal return on his investments. Take a simple case.
In the past 10 years, consumer inflation has ranged at around 6 per cent if you accept the official figures. Let’s say you decide that actual inflation has been around 7.5 per cent compounded annually and the official figure understates the actual inflation by 1.5 per cent.
If you receive a 10 year return of 5 per cent per annum, your nominal return is Rs 155. In order to keep up with a 6 per cent inflation rate however, your portfolio needs to earn Rs 169 and in order to keep up with a 7.5 per cent inflation rate, your portfolio needs to earn Rs 192. Since this difference compounds, the erosion in purchasing power grows steeper over time.
The most common error in financial planning caused by the money illusion is to assume that fixed rate instruments are safe. They are not – only some special classes of fixed rate instrument such as provident funds will offer an easy ride that beats inflation. Those have ceilings. You would have to time your entry to ensure that you get a rate that is higher than the long-term inflation rate. Or you would have to trade by buying and selling the right debt funds at the right time. And don’t forget to factor in tax on your interest income.
Elderly people who have invested their pensions in safe instrument usually end up seeing the value of their money erode at a point of time when they cannot afford to take risks, when they have higher contingency medical expenses and they have few if any, other sources of income. This is one of the cruellest effects of the money illusion as well as being the most common.
Let’s say that you avoid this particular money illusion and accept that you have to invest some proportion of your savings in higher risk, higher gain assets like equities. Let’s also assume that you are a fundamental investor who looks at earnings per share and EPS growth rates.
The Nifty has seen a nominal standalone earnings growth rate of 15 per cent in the past 10 years. So there’s a handsome premium over inflation in terms of EPS growth. In terms of capital appreciation too, the index has returned around 18 per cent CAGR, which is an even more impressive premium.
But do you inflation-adjust earnings in analysis, especially in stock-specific analysis? Corporate balance sheets offer nominal numbers. A rising EPS growth rate, which is not inflation-adjusted, can be extremely deceptive. Quite a few insights can be derived from avoiding this more subtle money illusion because it tells you which businesses are inflation-proof in terms of earnings stability.
