Inflation is a menace that almost silently erodes your wealth. Inflation which represents a rise in prices, results in a decline in your purchasing power. One of the goals of your investing plan should be to beat inflation.
This post analyses how bank deposits compare vis-à-vis inflation. Additionally, comparison is also on the basis of Inflation vis-à-vis Sensex (equities).
The above table showcases the data for 22 years timeframe on following attributes:
a) 1 Year Bank Deposit Rates (%): Deposit Rates for “1-3 years”, higher end of the range picked.
Source: http://www.rbi.org.in/scripts/PublicationsView.aspx?id=12765
b) CPI Inflation (%): Consumer Price Index – Annual Average for “Urban Non-Manual Employees”.
Source: http://www.rbi.org.in/scripts/PublicationsView.aspx?id=12731
Data for 2010-11 assumed to be similar to 2009-10.
c) Sensex Returns (Y-o-Y basis): Calendar Year, 2010-11 Returns (Year-to-Date): Until “9-Sep-2011”.
The average “deposit rates” for the mentioned year comes out to be 9.16%. The average yearly CPI inflation comes out to be 7.89%. The deposit outscores the inflation on an average basis by 1.27%.
For “Sensex”, the average yearly returns are 20.85% vis-à-vis the yearly CPI of 7.89%. The Sensex on an average basis leads banks deposits by 11.7%.
The inflation as can be seen from the table is in the higher band in the later year’s vis-à-vis the previous years. So, while the real return on both the asset classes remains in positive terrain, the margin varies significantly. In bank deposits, there is a margin of just 1% while with Sensex it stretches up to 13%. This means that in bank deposits there is very little scope to accommodate any shocks and one shock of course is that inflation may go northwards.
However, there are few more which are apparently visible:
1) Tax
Every year, the income that you earn on investments becomes liable to tax, depending on your tax bracket. As on date, long term capital gains tax is exempt but it’s not confirmed that things will remain as it is, going forward.
Let’s assume that if one falls in 10% bracket and analyze whether tax has any impact on one’s effective returns. Post tax, bank deposits fetches 8.24% returns and the real return from deposits comes out to be 0.35%. If the tax bracket is increased further, the real return from deposits slips into negative territory.
If we do some back of the envelope calculations for Sensex, tax eats up almost 2% of Sensex returns (10% tax bracket). Post tax, Sensex fetches 18.77% returns and the real return from Sensex comes out to be 10.88% vis-à-vis 12.96% (when tax is not considered).
2) Increased Expenses
Even if your bank deposits did break even, your retirement corpus would need to be able to provide for expenses that will increase post retirement, health care being significant.
Why Equities?
Equities stock prices are inflation adjusted because underlying companies posts results, which are inflation adjusted. Profits are inflation adjusted because if inflation goes up and costs increase, companies will increase their prices too in order to generate profits. However this stands true for good companies which are headed by able managements. They have the competence to deploy sound strategies to maintain margins, either by managing costs or increasing sales.
Equities are risky proposition, aren’t they?
Yes, but only in the short term, equities are risky. In the short term, prices of equity shares are driven by traders and speculators. They look for short term gains and bet on scrips on the basis of tips and information which may or may not turn into reality. However over a long term, all these short term volatilities get evened out and reflect the realistic growth of company.
This typically suggests that equities are good investments to for long term goals, that is, any goal ranging from 7 to 10 years or more. For medium term goals, which range from 3 to 7 years, a decent mix of debt and equity should be ideal. This also involves asset rebalancing when you reach close to goal attainment.
For short term goals, say less than 3 years, one should stick to debt instruments. One thing can easily transform into reality that inflation outdoes debt returns in the short term and you end up failing to attain the short term goals. To counter this, one might have to set aside a little more in that case. As the time period is short, impact cost may not be very high (as it is compounder over a short period).
Let’s assume, buying a car is the respective goal. The bank FD gives you 8% and inflation is 9%, the excess you might have to shell out to buy the car. This excess will be directly proportional to tenure one has set for the attainment of the goal. The more short-term the goal is the more provisioning one has to do for the excess money.
In no case whatsoever, equities can be short-cuts for meeting the excess. One might look for quick-profits from equities on the basis of a stock tips or a recommendations. But the envisaged quick-profits may transform into quick losses and the dreams aligned with the goal may shatter at that very moment.
On the contrary, one might have any provisioning for the excess money, so the solution for this is to defer the goal and set aside a reasonable time to meet that goal with proper planning. The compromise may not sound so good, but its much better w.r.t to a situation where “the short-cuts leads to long term miseries”.
Equities are indeed volatile in the short-term. Also remember, all your other goals can be postponed or pared down but not your retirement which is definitely a long-term goal.
This reiterates the fact that equities as an asset class, work best as a long-term instrument. As it assimilates all the short-term volatilities and reaps long-term benefits.
The trick is simple, to stay put for the long-term.
