Trading Rule – “Always Focus on Your Real Returns”…

Real return is a simple idea, most people fail to appreciate. Eventually, the real return you earn matters i.e. return after inflation. Nothing steals your investment value as much as inflation over a period of time. Not including inflation into your workings can give an erroneous and an extremely misleading picture of your investment health. Get a hang of real returns for that is what you really earn on your assets. It is all about getting real.

NEVER IGNORE THE IMPACT OF INFLATION

It is best to understand real returns with a live example. Assume that you had invested in a mutual fund which has consistently grown by 9% year-on-year. You make a back of the envelope calculation that it is better than an FD and hence you plump for this fund. What you possibly missed out in this entire calculation is the critical role of inflation. Let me explain.

The most conservative estimates for inflation today are at about 4-5%. Let us give ourselves the benefit of doubt and peg annual inflation at 5%. That means over the next 5 years your Rs.100 would have depreciated to Rs.77.40 as a result of inflation. In other words, your existing investment will have to grow by 30% in 5 years just to cover the impact of inflation. Real returns kick off only after that.

Rs. 100 invested in your 9% mutual fund would have grown by Rs.54, of which Rs. 29 is eaten away by inflation. To cut a long story short, your real return would have been around 4% annualized. Is that sufficient to cover risks like inflation shifts, commodity shocks, market risks, portfolio risks etc? Getting a hang of inflation gives you an entirely new perspective of asset returns.

WHAT EXPLAINS THE HUGE IMPACT OF INFLATION?

IT HAS A COMPOUNDING AND STICKY EFFECT

The power of compounding works negatively in the case of inflation. Hence, over a period of time, the impact of inflation gets magnified. Also, inflation tends to be sticky, by default, and takes time and macro efforts to improve.

INFLATION IS NEGATIVELY CORRELATED WITH EQUITY MARKETS

Inflation and equity values are normally negatively correlated. Higher inflation means higher discounting rate for future cash flows and hence lower present value. This problem is more pronounced for economies like India.

INFLATION IMPACTS THE VALUE OF THE CURRENCY

This is a major problem for economies like India which depend heavily on foreign portfolio flows. Higher inflation means higher depreciation of the currency, which prods many fund managers to book out of such markets en masse. A major risk for sure.

“There are two main drivers of Asset Class Returns viz. Inflation and Growth” – Ray Dalio

6 WAYS TO MINIMIZE THE IMPACT OF INFLATION ON RETURNS

  1. The quickest and simplest method of minimising the impact of inflation is by allocating a portion of your funds to inflation-adjusted bonds. These bonds are indexed to inflation and the returns are tweaked each time the inflation changes. The catch is that the index and your actual inflation may be different.
  1. There are certain classes of equities that are a natural hedge against inflation. High growth stocks, high dividend yield stocks, emerging sector bets are specific equity classes that can beat inflation. There is a catch. Emerging bets are risky, high growth stocks can be volatile and high dividend yields do not last.
  1. Hard currency defensives are again a natural hedge against inflation. When inflation has been high, rupee has been weak and the export driven companies like Infosys, TCS and Sun Pharma have done exceptionally well. We have seen that happen time and again. But, don’t ignore global macro cues.
  1. Counter cyclical stocks are always better bets in a high inflation scenario. Stocks like Banks, Auto and Real Estate tend to underperform in a high inflation scenario. The reasons are not far to seek. High inflation prevents rates from coming down and most cyclical stocks are rate sensitive. Hence, the dual impact!
  1. Gold and real estate have been two asset classes that have consistently beaten inflation, at least in selected pockets of India. Gold, however, has long cycles of upsides and downsides. Real estate over a period of 5-6 years has tended to better inflation. Including them in your portfolio surely makes a difference.
  1. Give a synthetic colour to your portfolio. Let me explain. You can include puts on indices that tend to get badly impacted by inflation to give a long-short colour to your portfolio. So while, your core portfolio bears the brunt of inflation in the form of lower real returns, your puts give positive returns to partly offset the impact of inflation. It is a little more complex but worth the trouble.

WHY INFLATION PERSISTS IN INDIA

Any investor who invests in India has to be conscious of the oversized role that inflation plays on asset returns. The reasons are not far to seek. A high dependence on imported crude and a persistent current account deficit has meant that we either generate or import inflation. A subsidy regime that is distorting also adds to the problem as Indian manufacturers tend to be complacent and have little incentive to enhance efficiency.

And it finally boils down to two additional items; poor infrastructure and a distorted tax regime. Both of them add to the inflation dilemma. According to conservative estimates better quality of infrastructure in terms of ports, roads, power and telecom can add 2% to GDP and cut inflation by 2%. That would straightaway add a whopping 4% to your real asset returns. And if tax structures are streamlined, as is being attempted now, then sky is the limit. Inflation, then, may not look bad, after all.

TAKEAWAYS FROM THE “REAL ASSET RETURNS” DEBATE

The legendary economist, Milton Friedman, had rightly said, “Inflation is nothing but taxation without statutory sanction”. Sadly both the investors and consumers tend to pay a heavy price. As we explained earlier, the compounding effect tends to distort your portfolio returns, much more than you can imagine. When you evaluate the performance of your investments, do not forget to impute the effect of inflation. It can actually be the difference between a “Yes” and a “No”. If you want to understand the full impact of inflation on equities, just look at what Paul Volcker did when he became Chairman of the Fed in the late 1970s. His battle against inflation launched the US markets into one of the longest secular periods of value creation in equities. It actually lasted for a full 20 years. Policy makers need to realize this, sooner rather than later.

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