A phone call between two friends leads to a talk about inflation-adjusted returns.
Akhila : What are you up to, Karthik?
Karthik : I was planning to buy a television set for ₹50,000. But I later changed my mind to save and invest that amount to buy a better version next year.
Akhila : I hope inflation doesn’t eat into your returns.
Karthik : What do you mean?
Akhila : A few economists expect inflation to rise going ahead. If that happens, your inflation-adjusted returns can be low or even negative.
Karthik : Can you explain that?
Akhila : If you invest that ₹50,000 at four per cent p.a. in a fixed-income instrument, your investment will be worth ₹52,000 by year-end. Say, the average inflation over the next one year is six per cent and the price of the TV set which you decided not to buy, becomes ₹53,000. Let alone buying a better version, your investment amount won’t be sufficient to buy even the current model.
Karthik : Ouch!
Akhila : Inflation-adjusted returns, also called real returns takes into account the inflation rate while calculating the return on an investment.
Karthik : How do I calculate real returns?
Akhila : You can simply subtract the rate of inflation from the return on your investment. In the above example, the real return on your investment would be -2 per cent. That is, 4 per cent return minus the inflation rate of 6 per cent.
Karthik : That’s pretty simple.
Akhila : The above formula gives an approximate rate of real return. To be precise, you can use the formula -- ((1+return)/(1+inflation rate)) – 1.
Karthik : Are there any savings instruments in the market that offer returns linked to inflation?
Akhila : There used to be inflation-indexed bonds but they are no longer available.
Karthik : Equities would give higher returns, right?
Akhila : Equity is said to deliver inflation-beating returns in the long-run. But remember, for the sake of earning higher inflation-adjusted returns, you should not go for investments that do not fit your risk appetite.
Karthik : What are the alternatives in the fixed income space?
Akhila : You can consider floating-rate instruments, coupon rates on which are linked to interest rate movements in the economy, which are a play of inflation as well.
Karthik : I remember reading the Simply Put column in BLPortfolio a few weeks back that talked about floating rate instruments such as Floating Rate Savings Bonds 2020, the PPF and the Sukanya Samriddhi Yojana.
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