Portfolio Ideas . How to manage inflation risk

One of the biggest risks you face in achieving your life goals is inflation. In this article, we discuss how inflation affects your lifestyle. We also show how to moderate the adverse effects of inflation on your life goals, whether you are a working executive or a retiree.

Inflation effects

Inflation impacts retirees much more than it affects working executives. Why? As a retiree, your biggest concern is to have enough money to fund your living expenses and healthcare costs, and healthcare inflation is typically higher than general inflation. So, an increase in general inflation would mean your healthcare costs would go up even more. Yet, your income may not keep pace with inflation. This is because you are dependent on investment income to fund your post-retirement living expenses. Importantly, most of your investments are likely to be in bank deposits that fetch a fixed rate of return.

Of course, lifestyle expenses would increase for working executives, too. But your active income somewhat helps you manage the adverse effects of inflation on your current consumption. You are, however, likely to feel the stress in meeting your life goals. Consider this. You are saving for your daughter’s college education eight years hence. You expect education inflation to be 10 per cent. But what if the inflation turns to be 12 per cent instead? Even though you may have saved every month and invested well, you are likely to fall short of the amount required.

That said, this shortfall will not hurt you as much as it would hurt retirees when they fall short of meeting their healthcare costs or living expenses. This is because while you can either borrow or transfer money from another goal-based portfolio, retirees cannot do so easily.

Proactive measures

When inflation increases and adversely affects your life goals, you may be forced to cut your lifestyle expenses and save more. What should you do instead?

Your investment portfolio should be geared to moderating the adverse effects of a likely increase in inflation. An optimal way to do so is to invest in equity. Why? We do not have inflation-hedging products in India. If your equity investments perform well, the wealth accumulated in your portfolio can catchup with inflation. Note that equity is not a hedge against inflation. It is just that the higher expected returns on equity can help you moderate the adverse effects of inflation.

Why not invest in other asset classes such as real estate or commodities? Indeed, rental income increases when inflation goes up. And commodity prices are typically the cause for inflation. However, real estate is illiquid and commodities are very volatile. The market may eventually offer products for hedging household inflation. Till then, you should consider taking equity exposure to moderate inflation risk. There is, however, an associated risk. What if the inflation goes up and equity markets tank? Not only will you face difficulty in meeting your goals because of inflation, but your existing portfolio would also suffer erosion in value. But that is the risk you have to assume.

By investing only in bank deposits, you will surely fail to achieve your goal if the actual inflation is higher than the expected inflation. By investing in equity, you improve your chances of achieving your life goals should the inflation increase.

True, investing in equity is risky. But sometimes, not taking such a risk is more risky, whether you are a working executive or a retiree.

The writer is founder of Navera Consulting. Send you feedback to portfolioidea@thehindu.co.in

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