Aim To Stay Ahead Of Inflation

Inflation is a factor central to investing, as it reduces the value of investment returns. Therefore, the most challenging aspect of your investment process should be to beat or minimally keep up with the rate of inflation in order to protect the value of your investments as well as returns earned. The impact of a higher inflation scenario on your investments would depend upon the composition of your portfolio.

Unfortunately, there are a number of investors who either do not recognise the threat of inflation to the wealth creation process or are not sure of the right way to tackle this threat. In an economy like ours, where inflation is persistently high, investors need to realise the importance of earning a positive real rate of return.

While the nominal return represents the growth rate of your money, the real rate of return represents the change in purchasing power of your money. Simply put, it is actually the real rate of return that indicates whether your money is growing in value or not. Since most investors focus on the safety of capital and invest a major share of their investible surplus in traditional options offering guaranteed returns like FDs, debentures and small savings schemes, the key aspect of earning positive real of returns often gets overlooked.

Considering that most of the traditional investment options offer lower returns and are taxed at one’s respective tax rate, the real rate of return usually turns out to be either negative or minimal. While it is true that in a higher inflation regime investors get an opportunity to earn higher interest on their investments in FDs and bonds, the tax inefficiency of these returns negates that benefit to a large extent. Investing in a tax-efficient investment vehicle like mutual funds can make a difference to the real rate of return. Some of the options like Fixed Maturity Plans, short-term income funds and income funds offering accrual strategy allow investors to earn higher returns.

Similarly, in a falling interest rate scenario, variants of income funds such as dynamic bond funds and long-term income funds can be a good bet. Investors in these funds can earn you benefits due to the inverse relationship between interest rates and bond prices.

If you are a long-term investor, have an investment plan in place should be the first step towards achieving a positive real rate of return. Though it can be quite a challenge to develop a strategy that can not only withstand the turmoil in different markets but also help in tackling inflation, you can achieve the desired results by focusing on the correct asset allocation. Another important step that needs to be taken is to curb your expenditure by budgeting them. This can help ensure that more money is available for investment every month.

While investing for the long term, the focus should on an asset class like equities, which has the potential to beat inflation. Equities also score over other asset classes in terms of tax-efficiency of the returns. Of course, when you invest in equities, you have to contend with the volatility that exists in the marketplace from time to time.

However, if your portfolio has substantial exposure to equity, the impact of higher inflation would be in the form of a falling portfolio valuation, as rising interest rates spell trouble for corporate earnings as well as the stock market.

While corporate earnings are generally able to outpace inflation in the long run, in the short-term investors get discouraged about investing in equities. Therefore, it is important that you honour your long-term time commitment and follow a disciplined approach to investing. If you do that, equities can be an ideal choice to stay ahead of inflation and accumulate a corpus that is usually required for achieving long-term goals like children’s education, their wedding and your retirement planning.

As an investor, it is important that you follow a tax-aware investment strategy. While mutual funds are a more tax-efficient investment option than many others, it is still important to invest with a clearly defined time horizon and chose the right option (dividend or growth).

For example, any capital gains arising out of an investment redeemed after 12 months is treated as a long-term capital gain. While long-term capital gains on investment in an equity fund are tax-free, investors are required to pay tax at a flat rate of 10 per cent for investments in debt funds. Similarly, dividends paid by mutual funds are tax-free in the hands of investors. However, for dividends paid by a debt fund, the fund house is required to pay a Dividend Distribution Tax.

Hemant Rustagi
CEO, Wiseinvest Advisors