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Suresh Krishnamurthy

INFLATION, as measured by the Wholesale Price Index, inched up over 6 per cent in recent weeks triggering a torrent of response. Reason: Fear of negative returns from investment. That is, negative returns after adjusting for inflation. However, such a threat has existed for quite a while now.

From an investor's perspective, this threat will from now on be omnipresent. This suggests that clarity regarding investment objectives is necessary to counter the threat posed by inflation.

Pocket impact: For retail investors, the Wholesale Price Index is not the relevant index for calculating the inflation rate. The Consumer Price Index is more appropriate. Inflation as per the CPI Index has been around the 5 per cent mark. In the case of some cities such as Chennai and Chandigarh, inflation based on the CPI had even crossed 8 per cent on several occasions in the past couple of years. In other words, the threat of negative returns has been around for some time now. In fact, the worry is that the CPI understates inflation.

What matters: What is relevant is how inflation pinches your pockets. The rate of increase in your annual expenses and how salaries increase to accommodate those expenses is what should matter to you. If the annual salary increase is enough to meet rising expenses then you are relatively safe.

In addition, for most investments, the average rate of inflation is not relevant at all. For example, in the case of investments made in buying a house or for funding education of children, what should matter is the expected increase in the price of real estate or education expenses. What would also matter is if returns from investments can beat the expected annual increase.

Real decline: It was not that long ago that a money market mutual fund was earning 8 per cent per annum.

After adjusting for inflation, of around 5 per cent, and taxes, an investor would have earned positive real returns of 0.5 per cent in a money market mutual fund. Now, a money market mutual fund is unlikely to earn more than 4.5 per cent before tax. Even if factoring in an inflation rate of 4-5 per cent, the real returns would be negative.

However, negative returns from an investment in money market mutual fund or a savings bank account is not what should worry investors. This is the trend in most countries — developed or otherwise. In the US, inflation is expected to be 2-2.5 per cent. A money market mutual fund in the US earns less than 1 per cent before taxes.

What should worry investors however is that even a 10-year government security will fail to beat inflation. A 10-year G-Sec yields about 4 per cent after taxes. If inflation continues to run above 6 per cent in the next few years, then for those years, the real returns would be significantly in the negative. In the US, a 10-year government security is expected to generate after-tax real returns of at least around 0.5 per cent.

Clarity in objectives: The perils of negative returns suggest the need for clarity in investment objectives. Suppose you want the present value of Rs 1,00,000 after 15 years and you can invest only Rs 5,000 each year. This means you need an after-tax real return of about 2.9 per cent per annum.

Debt investments cannot give you this return. So, you may have to step up your annual investments. For example, annual investments of Rs 6,000 will fetch a present value of Rs 1,00,000 if the after-tax real returns are 0.54 per cent. If you target a return of 0.54 per cent, then debt investments would be enough.

However, if you target 2.9 per cent, you have to consider including equities in your portfolio. But some investors may not be comfortable with equities. That means they will have to be content with a lower amount on their hands at the end of 15 years. A clear view on what you want will help in preparing better for what lies ahead.

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