In the world of investments, we are used to hearing words such as return on investment, guaranteed returns, very safe to invest, high returns etc. If you are a fearless risk-taker when it comes to investments, then your focus is usually on ‘returns’; on the other hand, if you tend to be more conservative, then it is ‘safety of the capital’ that is your primary aim. Sometimes however, even the fearless risk-taker becomes conservative after burning their fingers. This normally happens if the investments are focused on products, i.e. high returns, and not on the goal and time horizon.
The reason for the above summary of different kinds of investment goals is to lay the groundwork for the topic of this blogpost—inflation and safe investments!
A lot of conservative investors looking to secure their investments while having a long-time horizon should also consider the impact of inflation and how much their hard-earned money will be worth when they actually need it. I have always explained to my clients that all investments come with a risk, even the safest ones;this includes insurance policies that some clients consider as an investment product (as sold by many agents). That may lead you to wonder how a fixed deposit (FD) in a nationalised bank and an insurance product could be risky.
But the reality is that an FD and other safe products, too, come with a risk, which is called the ‘purchasing power’ risk. That means your money, after adding the interest at maturity, will not be as advantageous as it is todayand the insurance product will give you meagre returns. I have seen some of my clients getting 3% to 4% over 20 years, while some policies had a negative return, that too with a long-time term premium paying commitment.That is why it is important to check the real rate of return when investing for the longer term.
The real rate of return = (1 + Return on Investment/1 + Inflation rate) – 1
For example, if the return on investment is 7% and inflation is 5%, then the real rate of return = [(1.07/(1.05)-1]x100 = 1.90% .
Now let us see what happens if the scenario is reversed—if the return on investment is 5% and the inflation is 7%.
The real rate of return = [(1.05/(1.07)-1)]x100 = (-)1.86% . That is a negative return.
Negative returns on safe investments can actually eat up into your capital.
It is therefore important to understand the real rate, to invest wisely, as the inflation rate for different products and services is different and will affect your investment over a period of time. The data that is shared by the official body that looks into these aspects, the Indian Economic Services,may not be usefulfor your calculation. (Take a look at how the inflation rate is derived here: http://www.arthapedia.in/index.php?title=Headline_inflation).
For your calculation, you need to check your expenses over a period of time and check how your expenses are increasing (this will be your inflation rate)and draw your conclusions about the Real Rate of Return on your investments.
The most important aspect about investing, though, is having a clear plan to reach your goals. One needs to have the right asset allocation, taking into consideration the risk profile and time frame of the goals and needs. The investment product should be one of the final steps in the whole process. It is the best way to mitigate risks.
As investment guru Warren Buffett rightly said: Risk comes from not knowing what you are doing!
Thank you,
Anand Mhapralkar
CERTIFIED FINANCIAL PLANNER CM
+91 9820663784
Anant Wealth 