Mind your Inflation

How do I know if I am setting the bar too high or low with respect to my expectation on future returns?

First let’s address the question of the lower bar. What should be the bare minimum returns, I should generate over the long run.

In order to address this question, let’s take a step back and ask a fundamental question:

What is investing?

In simple terms, it is putting aside some money in the present in the hope of receiving more money in the future.

Today let’s assume I have INR 6 lakhs. I have the option of buying a car right now. But however I decide to postpone my purchase and instead save and invest the money in an F.D which offers me 8% return so that I can increase my money and buy a better car.  Fast forward 5 years, I have INR 8.8 lakhs and I am extremely happy as I have more money now. So as per our understanding of investing, we had put aside INR 6 lakhs five years back and received more money i.e INR 8.8 lakhs. Now I decide to buy a better car as I have more money. But I receive a shock when I go to the car showroom. The cost of the same car which I had wanted to buy 5 years back, now costs 9.6 lakhs !!

Though my investment had increased by 8% the cost of my car has increased by 10%. So while it feels like I have grown richer given the increase in money, the reality is that I have actually grown poor as the same car which I could have bought 5 years back cannot be bought now. Now why did this happen? The cost of my car increased at a higher rate than my returns.

This practical reality of higher costs is what a nerd calls “Inflation”. This means that our understanding of investing has to be tweaked to account for the “hidden thief” called inflation.

Let’s redefine investing from a practical point of view, as forgoing consumption now, in order to have the ability to consume more at a later date i.e Investing is not just about increasing money but the actual purchasing power.

Hence your investments should grow more than inflation to increase your purchasing power. So coming back to our question on what is the bare minimum return that one must strive to achieve – the returns must at least equal inflation if not more for preserving your purchasing power.

How do we know the inflation for the future. While I profess no prediction capabilities, as Keynes a famous economist puts it, the idea is to get it approximately right rather than precisely wrong.

Cost Inflation Index

Historically over the last 30 years India has had an inflation of around 7 to 8%. Hence its reasonable to expect future inflation to revolve around the same levels and therefore we set a cut off of a bare minimum at least 7.5% for your investments.

Let’s assume you have constructed an investment plan for generating a 15% return expectation. This means that your investments will be 4 times in 10 years while the costs would double (assuming 7.5% inflation). Hence an investment of 6 lakhs = purchasing power of 1 car will translate to approximately 24 lakhs while the car cost will be INR 12 lakhs. So after 10 years you will be able to buy 2 cars. Translate that into 20 years, you will afford 4 cars and 30 years you can afford 8 cars.

This is how wealth is created – a combination of returns above inflation + adequate savings + long time period

Now what if inflation comes lower let’s say to around 5%. This would imply that a 13% return is enough to replicate the same impact of a 15% return under 7.5% inflation scenario. Similarly if inflation becomes higher at 10%, then we need around 18% to replicate the same impact. So you can notice that there are three different returns 18%,15%,13% yielding the same result. The reason is the underlying not-so-obvious component – Inflation.

Thus the idea is that your return expectation instead of being fixated to a number should be relative to inflation. This is called real returns (actual or nominal returns – inflation). In the above case the real return is around 7.5% (15% actual return – 7.5% inflation). Hence when you set your target for an investment portfolio and are evaluating your returns focus on the real returns and not on the actual or nominal returns.

Quick Takeaway:

  • Investing = increasing purchasing power and not just money
  • Inflation is the not-so-obvious culprit which steals away your returns; Keep an eye on it
  • In India, Inflation historically has been around 7-8% ( basically that means our costs go up 2 times every ten years)
  • If your returns are below inflation, you are doing a bad job
  • Focus on real returns i.e Actual returns – inflation

Now that we have a fair idea on compounding, inflation and real returns let’s move to our next question

How do we set reasonable return expectations for our investments?

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Great Expectations !!

Recently I had a conversation with a family friend of mine, who also happens to be a CFO in a leading Infrastructure company. Since I was working for a wealth management firm, he casually asked me on how much returns do our clients generally make. I answered “mostly around 12-15%”. For a minute he stood shocked. “What?? Just 12-15% …I thought you guys must be making at least around 30-35% returns for your clients”..It was my turn to be shocked !!

This question serves as an inspiration for this post. Now before we move on, pause for a second and answer this. How much return do you expect from your investments (real estate, stocks or mutual funds or gold etc) for the next 20 to 30 years. Is our current expectation in line with reality? If no, what returns can we reasonably expect from our investments. The following post will try to address these questions. Have you heard about the magic of compounding? I know this concept has been beaten to death, but somehow intuitively most of us tend to find it extremely difficult to appreciate its relevance in our lives. Let’s understand its beauty, by taking an example of someone who expects to make 15% annualized returns.

Compounding formula: 

Final value = Invested amount * (1+returns)^no of years 

  Compounding @ 15% (graph)
The above illustration indicates the no of times your money is multiplied. For eg at 15% annualized returns your initial money invested multiplies 4 times in 10 years

Did you see that!!

While the effect of 15% returns on your investment is gradual in the initial years the impact magnifies dramatically as your investment period increases.

The logic is pretty simple – you can see that the money approximately doubles every 5 years. As you move past the first 20 years, in the next 5 years your doubling effect is phenomenally magnified given that you already have a 16 times initial amount as your base. Similarly between 25 to 30 years the multiplying effect is doubling on a 33x base which gives you a 66x returns. So as seen, an additional wait of 5 to 10 years brings about a significant change in your final investment value or put in other words, the earlier you start the higher is your future wealth.

Hence the key thing to remember is:

Compounding or the multiplier effect is back ended

To benefit from compounding we need to have 3 things in place:

  • Adequate savings to be invested
  • A reasonably long time horizon for investing – Start early !!
  • Consistently generate superior returns over a long period

For a much better and deeper understanding on the topic, please refer to the link by a brilliant blogger called Jana – https://janav.wordpress.com/2015/10/03/lecture-notes-the-joys-of-compounding/

 Long term Compunding @ different rates

Now that we can appreciate the effect of long term compounding better, let’s go back to the initial conversation that I had. Remember the shock that someone couldn’t earn even 30-35% returns. Now to put that in perspective, if I could consistently earn 30% return, it implies a multiplying effect of 2620 times in the next 30 years or 190 times in the next 20 years. Just take some time to register the impact of these nos. It means if I have 1cr and I can generate 30% returns I am staring at 2,620 cr in 30 years and 190 cr in the nest 20 years. Phew !!

So the next time someone tells you he made 30% or more (blah blah) in a year investing in this land, property, xyz stock etc… Pause. Ask him “Boss..Will you be able to do this for the next 10-20-30 years. Do you have any idea what that means in the long run ?”

The idea is not to conclude that generating high returns (lets say >20%) is not possible. But the fact that generating higher returns consistently over the long term is definitely not easy.

You had also started with some expectations in your mind. Check with the table to appreciate the true long term impact of your expectation. Is it too high? Will you be able to do that consistently over the long term?

While there will be several investments which do well in the short run, what really matters is not the returns we make over a 1 or a 3 year period, but the ability to “consistently “ generate superior returns over a long term. Hence it is extremely important that we do not get carried away by abnormal returns in the short run but rather have a reasonable idea on the long term potential of your investments.

This leaves us with a few questions:

  • How do I know if I am setting the bar too high or low with respect to my expectation on future returns?
  • How do I put in place a plan to generate “consistent and superior returns” over the long run
  • Given my requirement and needs, what is the adequate amount to save and invest?
  • Does it require a lot of knowledge and time?
  • Is it possible to improve my returns?

(to be continued)