Inflation and psychology!

Inflation story continued………

Psychological Impact of inflation is quite harsh on the investors and savers. Economic theory says when inflation is high, people will tend to spend more – because there is no incentive to save. This is true to a very limited extent. Most people get so scared that they start saving more and reducing their expenses. Let us look at a person who is targeting a post retirement income of Rs. 120,000 per annum. If the retiree is told that this will not be enough, he saves more – instead of looking for an asset class which gives a positive real return over longer periods of time.

It is inflation which makes even ‘evergreen’ schemes like Public Provident Fund look like a bad scheme in the long run!

Ronald Reagan warned us to be ever vigilant of a threat “as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.”
Just what was he talking about?
It wasn’t Iranian terrorists… A Russian nuclear sub… Or Osama!
No. Reagan was talking about the thief that robs us all… Inflation!

What impact inflation has on your portfolio is a function of the type of portfolio that you have created. The savings portfolio (bank fixed deposits, national savings certificate, public provident fund, kisan vikas patra, postal schemes, company fixed deposits, gold, etc) will be eroded by inflation. If returns remain constant, and inflation is positive (which always happens in a growing economy) the returns and the principal are both not keeping up to your requirements in ‘real’ terms.

Investing in shares and trading in real estate are perhaps the only assets which gives you a protection against inflation. Buying one house and living in the same house for a long period of time is a good saving asset, but not a great investment asset. However, if you buy and sell real estate, give it on rent, leverage against the forthcoming cash-flows etc. you will be able to get returns in excess of inflation.

Investing in equity shares – either in direct equities or through mutual funds – protect themselves against inflation.

This happens because in the longer term at least a company’s sales and profits after tax should increase at least at the same rate of inflation. The skill for an investor is to realize that inflation is relentless but equity growth can happen in fits and start – this can test a new investor as well as an impatient investor. The other worry about the income of a company is the income gets overstated during inflationary times. It is important for the investor to know the difference between nominal growth and real growth. Estimating the income of a Information Technology company and seeing whether it is doing well should be done without the impact of exchange rate. Similarly it is necessary to find out the impact of inflation in the results of a company –especially over a long period of  time.

Another problem that inflation creates is that it increases costs – and this slows down the economic development. Higher interest costs increases higher expected returns on the riskier assets. This makes it difficult for entrepreneurs to raise capital – and slows down the capital formation too. Sometimes this leads to a financial contraction – leading to a supply side inflation too.

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4 Responses to “Inflation and psychology!”

  1. Dr Mohammed Ali Khan on January 9th, 2010 at 11:23 am

    Gold will also be eroded by inflation?
    I thought that it was a hedge against inflation..

  2. nice detailed post .

    Inflation is the least understood and considered factor . i am amazed at people who invest in those guaranteed return products which promise to make your money double in 10 yrs . I am talking about those LIC policies like jeevan astha and jeevan Nischay . Where is god ?


  3. Dr Mohammed Ali Khan on January 9th, 2010 at 7:39 pm

    “God is dead”
    – Friedrich Nietzsche 1884

  4. God is always with the guy who makes money. Underdogs believe God is on their side. God is in the details and in the information. Fools do not like details nor do they like info….

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