A Hole in your Pocket - How to avoid worry?

Before we jump ahead to mitigate the impact of a worldwide problem, let's get to know the elephant in the room - 'INFLATION'.

Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. It can be caused by many factors, but essentially it happens when prices rise faster than the rate at which wages are increasing. In most developed countries, inflation has been a persistent problem, with prices shooting up more quickly than wages.

Is Low Inflation of any worry?

If high inflation is our problem, is low inflation any better?

There are two main reasons why low inflation could be bad.

First, it causes investors to receive low returns on investments. If investors feel the return on their money will be low, they might be less likely to save or invest further in the economy. This can put a strain on the economy as fewer people have money available to spend in the economy, resulting in a decreased demand for goods and services.

Second, low inflation can cause people to expect wages to stay low, as they have been for a longer period of time. This can force workers to choose between two options: accept a lower standard of living or accept a lower wage. It is bad not only because it can cause financial stress, but also because it can cause social issues. Low wages can cause people to feel like they are unable to provide for their families, and this can lead to several problems.

How do Governments tackle Inflation?

Insight into strategies deployed by governments helps us understand better how higher inflation can have a bearing on our financials.

Raise Interest Rates

Contractionary monetary policy is now a more popular method of controlling inflation. It aims to reduce the money supply by raising interest rates. This slows economic growth by making credit more expensive and reducing consumer and business spending.

Issue of Government Bonds

The central bank can initiate the issue of government bonds and securities to commercial banks and encourage them to purchase them. When the banks purchase these securities, they have less money available to lend to the general public. Consequently, the money supply in the economy is reduced, and the inflation rate decreases.

Price control

It is the process of establishing a minimum and maximum price for certain items. Price controls increase the affordability of those items, generally consumed necessities like fuel and gas. When it is used for a long period of time, it can have serious repercussions like shortages, encourages hoarding, poor quality product, etc.

Curb government spending

If the government is spending more money than they are earning, it plans to cut back on this expenditure. This will force them to make cuts in areas like health and education, but it will also reduce the demand for other goods that are unnecessary.

Reduce imports

The higher the inflation rate, the higher the cost of imports and the higher the cost of living for everyone. As a result, it negatively impacts the economy by increasing the cost of importing goods, which can result in an import-substitution crisis. To prevent this from happening, the government can raise import tariffs when the inflation rate is high. Import tariffs are taxes that are levied on foreign goods.

If commodities such as food, fuel, and minerals experience high levels of price inflation, then it is likely that tariffs have not been high enough. Government increases the tariffs on these goods, to slow the level of price increases.

Increase taxes

The government may increase tax rates to raise revenue and decrease private spending.

Impact of Inflation on the Value of Money

How inflation affects savings and investments is crucial to understand as an investor. Inflation indicates an increase in the prices of goods and services in an economy and it is crucial to grasp what it means and how it affects savings and investments. Money depreciates over time, so whatever you buy today may cost more in the future. As an investor, you must consider both nominal and real returns. A nominal return is a return you get without factoring in inflation. Real return, however, is derived after adjusting inflation. When the value of money falls, you need investments offering higher returns that can beat inflation.

The CPI (Consumer Price Index) is a measure of inflation. When you pay more for an item today than you did last month, it’s easy to see that as a sign of inflation. However, things aren’t always that simple.

For example, if the price of milk goes up 10%, it’s going to cost more money for you to buy milk now than last month. Let’s say you only spend Rs 200 on milk every other week to keep your family happy and healthy. With no other alternatives available, you will have to compensate by spending less on something else. If your income stays level, your spending will drop as you can't afford as much. This leads us to make tough choices about what to buy and how much to spend on them.

Are Bank FDs the safest haven during Inflation?

Although bank fixed deposits are considered the safest option, they lose value due to inflation. Many of us keep our money in bank FDs because they appear to be the most secure. However, inflation reduces the value of our savings. To understand this example, let's say you have Rs 1,000 in your account. If you get 5% interest, your deposit will increase by Rs 1050. If inflation rises by 7%, an item that cost Rs 1,000 earlier would currently cost Rs 1,070. Despite an increase in your investments, you would need to shell out more money due to inflation. Consequently, you lose out on the 'real' return from the investment.

Real Rate of Return = (1 + Return%) / (1 + Inflation Rate%) - 1

Calculation - Real Rate of Return

This means a household with Rs. 10 Lacs annual expense, post 20 years will require 38.7 Lacs per annum to maintain the same living standards. This is primarily due to the impact of inflation of 7% per annum.

If you are planning retirement and account for only 75% of the current expenses for future needs, you will need a whopping amount of Rs. 5.27 crores as the corpus to sustain 20 years into retirement.

The Truth About Inflation and Ways to Combat it

Little you can do to fight an increase in the cost of living besides saving, earning more, and curbing expenses. Many of us understand that if your money is becoming less valuable over time, inflation is affecting our economy. This is why it affects our lives so much; it forces us to make tough choices about what we buy and how much we spend on them.?

There are several methods to combat inflation. The conventional approach has always been about saving more and less spending. However, this does not help overcome the impact of inflation on our savings or prevent the devaluation of money. A more pragmatic approach is to project inflation in the future and adopt a smart investing methodology. This involves financial goal setting and asset allocation basis portfolio diversification strategy. However, this is easier said than done as nothing can be achieved in the short run. It requires proper planning, and commitment to achieve these financial goals. Let's look at some of the smart ways to manage our investments.

Fixed Annuity option to beat Inflation

You should look at short-term and mid-term fixed annuities if you want to protect your retirement accounts and weather a coming recession because inflation signs may appear, and fixed annuities provide guaranteed rates for two to five years. On the other hand, money market accounts and bank FDs offer little to nothing in the way of guaranteed returns; however, a mid-term to the long-term annuity can currently offer up to 7% guaranteed returns.

Budgeting and exploring Additional Streams of Income

Look for ways to reduce cash outflows by evaluating your personal budget expenditures.

Consider refinancing loans, consolidating debts for lower rates, and paying off debts.

Investing in yourself through continuing education can lead to new business ventures or supplemental income.

Invest in Inflation-powered Instruments

If you include treasury inflation-protected securities, shorter-term bonds, floating-rate instruments such as mortgage-backed securities, and collateralized debt obligations in your portfolio, they can help mitigate inflation concerns.

Beyond that, you might acquire commodities, real estate, and financial company stocks, which might benefit from inflation.

Invest in well-managed dividend-growing companies

Your retirement may last for over 30 years, and everything you buy today will cost 2.5 to 3 times more in 30 years if historical inflation rates persist. To maintain purchasing power, you should invest in an asset that can overcome this level of inflation. Well-managed, dividend-growing companies' stocks have historically outperformed inflation by 3% to 5% annually.

Hedge Inflation through Investment in Precious Metals

Fortify a portion of your wealth by holding inflation-hedge assets such as precious metals (gold and silver).

When to opt for FDs during Inflation - comes with a Caveat

Returns from bank savings accounts are significantly lower than inflation. Furthermore, accounting for taxes, FD returns may be negative. Unless FDs provide a couple of percentage points more than inflation, they will not be a good financial investment. That said, bank accounts or liquid funds are still an excellent option for parking emergency funds in case of any contingency. As interest rates surge, ladder your investments for a shorter time period to get a larger return when they mature. Laddering will also address liquidity issues and produce regular returns.

Review and Recalibrate Investments

You should have an investment strategy to combat the impact of Inflation.

One of the options for those with a great risk appetite is to opt for an Equity Mutual fund, which has generated a higher return than inflation in the past.

Investors with a Lower-risk appetite may consider Balanced Advantage Fund or other hybrid funds for investment.

Risk-averse investors may opt for Debt funds.

Ultimately, the investor's sole objective should be to invest in assets that preserve their money's value better than inflation does. SIP investment is the simplest way to benefit from market volatility and create long-term wealth which also helps money cost averaging.

Risk Appetite-based Investment and Portfolio Allocation

It's beneficial to speak with an advisor when inflation is on the rise, to ensure that your investment allocation matches your risk appetite. For example, a 60% equity and 40% fixed-income investment allocation might be appropriate for someone who values stability. If you're looking for income, consider shifting some of your money to dividend-paying stocks. Historically, stocks have been better at preserving purchasing power than bonds.

Seek Professional Help

The initial step is not to panic. Not all investments are negatively impacted by inflation. Next, you need to speak with your financial planner or investment and retirement advisors to ensure that your overall strategy has the plan to mitigate inflation's impact on your investments. If you have not prepared your portfolio for this risk, you will need to reconsider.

Conclusion

People often misunderstand inflation as a rise in prices, but in reality, it occurs when there is a rise in the supply of money. When the government prints more money than the supply of goods and services, it causes inflation. High inflation is a sign of an economy that’s overheating. When you invest in the stock market, you should be aware of the possible effects of inflation on your investment. Knowing the pros and cons of investing in different asset classes will help you make the most informed decision. Additionally, investing in an asset that is likely to give you high returns will help you outpace inflation. You should not avoid investing due to inflation but learn to beat it by investing wisely.

The best approach is to consult a financial planner to strategize and recalibrate investments to combat inflation.

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