When the rate of inflation exceeds the rate of return, it spells trouble for investors as the money invested continues to lose its purchasing power over the investment period. As the interest on fixed-return instruments – like fixed deposit (FD), recurring deposit (RD), taxable bonds etc – is generally taxable, people investing in such instruments suffer even more after the tax outgo brings the returns further down.
“High inflation unfortunately has an almost uniform impact on all investments – it tends to reduce the real value of returns,” said Nikhil Aggarwal, Founder & CEO at Grip.
The recent hikes in policy rates by the Reserve Bank of India (RBI) – as a part of inflation control mechanism – are not expected to provide immediate relief either, unless the investment money is shifted from the existing lower-interest instruments to the newly issued higher-interest ones.
Moreover, with the fall in market value of the existing lower-interest instruments, the long-duration debt-oriented mutual fund (MF) schemes having such instruments in their portfolios witness a fall in their Net Asset Value (NAV), thereby generating negative return for the investors.
“While some instruments – like the inflation indexed bonds previously issued by the RBI, etc – are the examples of some investment products that can act as a protection against inflation, most fixed income instruments don’t provide any such automatic cover,” said Aggarwal.
“The effects of inflation on an investment portfolio are also not necessarily straightforward and can take place in multiple ways,” he added.
Aggarwal lists the following three ways in which inflation may affect your portfolio returns:
- Central bank action to tackle higher inflation can result in an increase in interest rates and can cause your existing fixed income portfolio to reduce in value.
- Higher interest rates could also reduce liquidity, capex budgets and growth rates of businesses resulting in stock investors forecasting weaker returns from public markets. This is exactly what we are seeing happen as central banks across the world are guiding to higher interest rates.
- Inflation caused by shortage of supply of a particular commodity could result in a significant increase in its price. But such events are not always easy to predict and require a very detailed understanding of commodity markets.
So, what should investors do to reduce the ill effects of inflation on their portfolios?
According to Aggarwal – while there is no magical formula – investors can look at taking the following steps to better manage their portfolio in such times:
- Begin investing in fixed income instruments as interest rates increase. If you want to have a total allocation of Rs 100, begin investing in smaller tranches as and when rates increase. This will allow you to have a high yield portfolio when inflation starts reducing.
- Always aim to have a more diversified portfolio. As inflation may impact different asset classes differently, you might be able to mitigate the impact better.
- Consider adding some higher yield/ higher return earning investments in your portfolio. Such investments come with higher risk but can provide returns significantly above the inflation rate. Over the last few years, several investment platforms allow you to make such alternative investments at low minimum amounts giving you the ability to both diversify and increase the potential of returns.