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This is an archive article published on June 21, 2008

Do you know inflation has eaten into your returns too?

As inflation tightens its grip on the economy, the real rate of return on most investment options is withering.

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As inflation tightens its grip on the economy, the real rate of return on most investment options is withering. Most fixed income securities are now giving negative real returns (real rate is nominal rate minus the inflation rate). With equity markets also in the doldrums, investors’ options have shrunk even further.

Under present conditions, only gold exchange traded funds (ETFs) — with 41 per cent return — offer some respite. Trading in a range-bound movement, markets are now giving 5.54 per cent return. Since a large component of the current inflation comes from the rise in fuel prices, one option for households is to cut down on their fuel expenses, say by planning their trips more carefully.

If you have taken any debts, you should try and prepay them. According to Pune-based financial planner Veer Sardesai, “You should move from floating to fixed rate loans as this will allow you to plan your finances better.”

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If you continue to have your money invested in ‘safe instruments’ such as PPF (8 per cent tax free returns), Senior Citizens’ Saving Schemes (9 per cent), and fixed maturity plans of mutual funds (post-tax yield of 8.5 per cent), you will lose out in the long run as your investments will yield negative returns. As interest rates go up, banks will also revise their deposit rates upward. But the net real return from fixed-income instruments is still likely to be negative. However, for liquidity-related considerations, six months’ expenditure should be retained in fixed income securities, despite negative real returns.

Over the long term, to beat inflation, you will have to invest in inflation-fighting assets, of which there are two — equities and gold. At a CAGR of 18 per cent, returns from gold have been robust over the last three years. But over the long term, gold is likely to beat the inflation rate by 1-2 percentage points.

But if your investments are to outperform inflation over the long run by a considerable margin, only equities can help you achieve that. But these inflation-beating returns from equity will come only over long-term horizon of three-five years. In the short term, as high inflation drives interest rates up, both investment by corporates and consumption by individuals is likely to shrink. One way that high-risk investors can actually profit from the run-up in commodity prices is to invest in mining companies, and refineries, including those abroad.

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