When you grow up in a middle-class Indian family, one consistent theme in conversations at home is “everything is becoming quite expensive.”
It is a ritual for the family to put together a budget to plan monthly expenses and see the rising prices destabilize it. For most families, it is a vague concept that raises many questions:
1) Why are prices going up?
2) Who was increasing the prices?
3) Is there a way to manage this better?
Inflation in my formative years- The 90s
Between 1990 and 2000, average inflation in India was 9.5% p.a. This meant that you had to spend Rs. 248 in 2000, to buy the exact item that you spent Rs. 100 on, in 1990. Having lived this reality, I developed a better sense of this phenomenon called inflation. Fuel prices increased by 3x during this decade- from Rs. 10 per liter to almost Rs. 30 per liter.
What is Inflation? How does it impact our lives?
Let’s divide this discussion into two parts:
I. Focus on understanding the concept of inflation
II. Map the financial life of a typical family and the role that inflation plays
I. Deep dive into the concept of Inflation
Inflation is a rise in the prices of goods and services and we encounter it due to two factors: economic and lifestyle. Let’s understand both of them:
1. Economic factors
Cost-push inflation: Increase in prices due to rising input costs. For example, a sugar company increases prices as a result of rising sugarcane prices.
Demand-pull inflation: When the supply of money exceeds the demand, the purchasing power of money falls and too much money starts chasing too few goods. We are witnessing it currently because during the covid crisis, all the central banks increased the money supply and that has led to the higher prices.
2. Lifestyle factors
One under-acknowledged reason for inflation that affects our lives is on account of lifestyle changes. As human beings, we constantly aspire to upgrade our lifestyle leading to an inadvertent increase in our expenses. While estimating expected inflation, it is important to factor this in.
Make your savings work for you
We earn money through businesses or professions that we engage in and use it to buy goods, services, and assets. The residual amount is our savings that are stored to meet future planned and unplanned expenses. This cycle of earning and spending continues until retirement. Unfortunately, the working life is finite, and expenses continue well beyond that. For this, we need to build our savings. In case the return generated on our savings is unable to keep pace with the inflation, it may reduce the ability to meet expenses.
In order to understand this better, we’ll closely map an individual’s financial journey below.
II. Mapping the financial journey
To understand the expenses, savings & portfolio growth patterns of an individual, we have assumed the following attributes to project finances across his/her lifespan:
1.Starts earning at the age of 24 yrs. with a yearly salary of Rs. 6 L, which grows by 9% every year
2.Retirement age – 60 yrs.; Life expectancy – 85 yrs
3.Personal milestones
a)Married at 28 yrs
b)Two children are born- one at 30 yrs; the second at 32 yrs
c)Home purchase at 40 years with an annual EMI (Equated Monthly Installment) of Rs. 15L for 20 years
4.Economic inflation assumed at 5% p.a. & lifestyle inflation at 3% p.a.
5.Savings from salary, post expenses, grow 9% annually
Simulating these parameters, the financial portfolio of the individual will tentatively appear as below:
Observations:
1.With expenses increasing year on year, the portfolio will grow till the age of 60 due to compounding & additional inflow of savings.
2.Expenses decrease at the age of 55 & 57 years, as we assume the children will now be financially independent as they turn 25 years.
3.The impact of inflation increases with time as prices of goods grow and lifestyle improves
4.The corpus built till 60 years, will be utilized to generate expenses during retirement
With the above assumptions, the portfolio created will last till 85 years exact, meeting the life expectancy. However, any costs due to any other life events or unforeseen/medical events have not been accounted for.
In order to account for different circumstances, let’s create projections for different scenarios to understand the sustainability of portfolio returns:
The impact of inflation increases with time. Hence, it is critical to build portfolios that not only surpass economic inflation, but also cater to your lifestyle needs and help maintain them post-retirement. Additionally, a safety net should be built to have a substantial cushion, in case of any unforeseen event.
How can you construct a portfolio that beats inflation?
Moderate inflation keeps the engine of growth chugging and is considered healthy. However, it disproportionately impacts individuals who are moving towards the latter half of their lives and are dependent on their savings to meet expenses.
To consistently beat inflation, a scientific asset allocation process should be embedded in the foundation of the portfolio. This allocation should be decided as per the individual’s long-term financial goals and aligned with his/her risk tolerance levels.
Let’s get an overview of these assets.
Asset classes can be classified in 3 categories:
1.Risk-free assets that typically generate returns less than inflation-
a.)GSECs (government securities)/ bank fixed deposits
2. Assets classes with positive correlation with high inflation
b)Real estate and gold
3. Assets that are volatile in short term but beat inflation by significant margins in the long term
c) Equities
It is important to design a portfolio with reasonable exposure to the asset classes that perform better than inflation and can maintain and increase the purchasing power of the investments. However, it is important to note that during differing market conditions, the instruments within each of these classes might generate different returns.
In summary, inflation plays a significant role in management of finances and it is important to periodically measure its impact on the expenses and also to actively check whether your investments are able to keep pace with that. In case there is a gap, investors should modify their investment mix to meet/beat the inflation impact.
Author: Vaibhav Porwal (Co-founder — dezerv.)
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