Inflation Proof Portfolio

Inflation is something that reduces the purchasing power of money over the period. Simply put, it is a passive money-eater acting like slow poison. Therefore, to combat this you need to have a strong investment portfolio that will not just help you to cover inflation risk but also let you create wealth over the long term 

Inflation is potentially one of the greatest evils for investors. It destroys your savings and your planning gets haywire and reduces your standard of living. It affects all aspects of the economy from business to employment rates and consumer spending. It affects the tax policies, government programmes and interest rates. Therefore, understanding inflation is vital for you as an investor. This is because inflation can have a negative impact on the investments that you make and the returns that you earn.

Recently, we have seen a spike in inflation rates not just in India but globally. In India the inflation picked up pace from September 2021 when its rate was 4.35 per cent, which grew to 6.01 per cent in January 2022. This means a growth of almost 50 per cent in inflation. The inflation rate has consistently been rising since February 2021 globally, including USA. The inflation rate in USA has increased from 1.7 per cent in February 2021 to 7.5 per cent in January 2022.

The table above clearly shows that inflation around the globe is elevated. In fact, countries witnessing negative inflation (deflation) such as Japan are also witnessing inflation moving into the positive territory. In India, the Reserve Bank of India (RBI) is in a big tussle to control inflation along with boosting economic growth. Most of the central banks around the world, including the US Federal Reserve, have either been tightening the monetary policy or giving indications to start this soon. This is to suck the excess liquidity in the market and control the elevated inflation. However, the RBI is still holding its accommodative stance to support economic growth.

That said, another reason for the shooting up of inflation is the geopolitical event being played out between Ukraine and Russia. And this is also the reason behind the stock markets having a negative bias. This event is affecting investors in two ways: one with falling portfolio returns due to tumbling stock markets and the rising rate of inflation that will ultimately lower net return on investments. The real rate of returns is nothing but your portfolio returns adjusted for inflation.

For an individual investor, inflation is one factor that is beyond control. This means that you don’t have any choice rather than to accept this fact and plan your finances in such a way that you either beat inflation or at least try to minimise its impact to a great extent. In this article, our aim is to help you create an investment portfolio in such a way that you would be able to beat not just general inflation but personal inflation too. 

Understanding Personal Inflation
When we say general inflation, this is headline inflation which measures the increase in the prices of goods and services irrespective of an individual’s expenses. However, personal inflation is more of a customised inflation. This means the inflation that is linked to your personal expenses. Here another question might pop up as to why at all you need to account for personal inflation. The rationale behind this is that people have their unique cash flows in terms of income and expenditure. Therefore, their inflation should account for the same. Say, for instance, those who are single would have fairly different kinds of expenses compared to couples. For both of them inflation would affect differently. Therefore, it is important to assess your personal inflation while planning your personal finances.

Estimating Personal Inflation
Although it sounds difficult, it is not that hard to estimate your personal inflation. All you need to do is to first list down all your expense in percentage terms of your total expenses. Then go to the website https://dbie.rbi.org.in/DBIE/dbie. rbi?site=home, which is the RBI’s portal for economy data and look out for CPI - Rural, Urban, Combined in the indicators’ section. Once you click on that, you will get detailed inflation data for each product and service. Then multiply the inflation with the respective expense. Finally, sum up all those inflationadjusted expenses in percentage terms and you will have your personal inflation. Remember, this is unique to your expenses and hence don’t try to use someone else’s inflation.

1. Exchange Rates
Exchange rates are one of the most essential factors in determining the rate of inflation. When the exchange rate suffers such that the rupee becomes less valuable relative to foreign currency, this makes foreign goods more expensive to Indian consumers while simultaneously making Indian goods, commodities, services and export cheaper to consumers overseas.

2. Money Supply
The value of money is determined by the amount of currency in circulation. When money supply outpaces growth in economic output i.e., when more money is chasing the same amount of goods, the increased demand provides firms with the opportunity to raise prices, consequently resulting in inflation.

3. National Debt
National debt can drive inflation to higher levels over time. A country in national debt has two options – either raise taxes or print more money to pay off the debt. If the government increases taxes, businesses will react by increasing their prices to offset the increased corporate tax rate. If the government chooses the latter option, it will directly lead to an increase in money supply, leading to a devaluation of the currency and contributing to inflation.

4. Demand-Pull Inflation
This inflation occurs when the overall demand for services and goods in an economy increases swiftly than the economy’s production capacity. This creates a demand-supply gap with higher demand and lower supply resulting in heightened prices. For instance, if the oil-producing countries decide to cut down the production of petroleum and other hydrocarbons, the supply decreases. This lower supply for existing demands results in a rise in the price and contributes to inflation.

5. Cost-Push Inflation
This theory states that when industries face increased input costs such as wages or raw materials or goods, they serve their profitability by passing this increased cost of production to the consumer in the form of higher prices, which further contributes to inflation. For instance, if the cost of milk increases, the cost of each cup of coffee at your local restaurant will also increase

6.Built-In Inflation
As the price of goods and services increase over time, labourers or employees expect more wages or salaries to maintain their cost of living. Their increased wages or salaries results in higher cost of goods and services.

The Study
In order to understand how to beat your personal inflation, we carried out a study wherein we have come up with investment portfolios that will help you beat the inflation. To do so we have assumed three personal inflation rate scenarios of 6 per cent, 8 per cent and 10 per cent. Moreover, we have created a portfolio of equity, debt and gold where we have assumed Nifty 500 TRI as the representative of equity funds, medium duration funds as representative of debt funds and Aditya Birla Sun Life Gold ETF as a representative of gold. You can have your own choice of portfolios with the same set of assets.

For our study we would be calculating inflation as well as portfolio returns on ₹ 1 lakh for 10 years. Our period of study ranges from March 2012 to February 2022. When it comes to returns provided by each asset class, we have calculated five-year rolling returns over 10 years for Nifty 500 TRI, average of medium duration funds and Aditya Birla Sun Life Gold ETF. After this we got 15.8 per cent, 8.2 per cent and 5.6 per cent annualised returns for Nifty 500 TRI, medium duration funds and Aditya Birla Sun Life Gold ETF, respectively.

Portfolio to Beat Personal Inflation

1) Personal Inflation of 6 Per Cent : In order to beat the 6 per cent of personal inflation you can simply invest in a portfolio of medium duration funds as they offer you return of around 8.2 per cent annually on an average. However, the thing to remember here is that the average maturity of the fund should not be more than five years. Therefore, people having personal inflation of 6 per cent can beat inflation simply by investing in a debt fund where the risk is comparatively lower than equity.

2) Personal Inflation of 8 Per Cent : If you have a personal inflation of 8 per cent, investing in medium duration funds can only cover the inflation and would not be able to create wealth for you. Therefore, in order to beat inflation and have favourable real rate of returns you need to invest at least 30 per cent in Nifty 500 TRI, 60 per cent in medium duration funds and 10 per cent in Aditya Birla Sun Life Gold ETF. This will bring your weighed portfolio returns to 10.24 per cent.

3) Personal Inflation of 10 Per Cent : If in case your personal inflation works out to be 10 per cent, then you have to take on more risk to beat inflation. Therefore, to have a reasonable real rate of returns you need to invest at least 60 per cent in Nifty 500 TRI, 30 per cent in medium duration funds and 10 per cent in Aditya Birla Sun Life Gold ETF. This will give you weighed portfolio return of 12.52 per cent.

Inflation and Financial Goals

Inflation is not just restricted to your expenses but also to your financial goals. Every person has his or her unique lifestyle and financial circumstances. Hence, their financial goals too are unique and in order to achieve it in a more real sense, inflation needs to be accounted for. Every financial goal carries different inflation. Financial goals such as education, healthcare and recreation had an inflation of 10 per cent, 8 per cent and 10 per cent, respectively, for the year 2021.

In order to beat this, you need to have an aggressive portfolio. In fact, every financial goal call for a unique portfolio dedicated to that goal. This means that for some goals such as healthcare corpus for retirement you might not need to take higher risk and hence having a moderate portfolio here makes more sense. However, in case of education goal you might need to have a portfolio that is risky and is more tilted towards equity.

Conclusion

Inflation is something that reduces the purchasing power of money over the period. Simply put, it is a passive money-eater acting like slow poison. Therefore, to combat this you need to have a strong investment portfolio that will not just help you to cover inflation risk but also let you create wealth over the long term. However, it is important to understand inflation from various angles and not just from a generalised perspective. Generalising inflation might create a shortfall in the required corpus. Therefore, personal inflation is the best way to account for inflation. However, different financial goals carry different inflation weightage and hence the portfolio should be unique depending upon the inflation that it bears.

In this story we have tried to put forth the portfolio for various personal inflation levels. This will not just help you to cover inflation but also create reasonable real rate of returns. Having a good combination of equity, debt and gold would help in fighting the inflation that is at the higher end. Moreover, we would recommend avoiding unnecessary risk by investing more than needed in riskier assets. Rather, just aim at beating inflation. Furthermore, do not forget to rebalance your portfolio periodically. This will help you in reducing concentration risk and help you to beat inflation.