June 9, 2008

Inflation and portfolio strategy

With inflation at 9% or higher (depending on the numbers you believe), it may be too late to profit from the increase, but it makes sense to re-construct your portfolio to reduce the impact.

My plan, which I detail in this post, is a mix of reading and personal experiences. Ofcourse everyone has a unique situation, so my approach may not be valid for everyone. However some points may be of use to most of you.

1. Equity is one of the best hedges against inflation. Long term returns are definitely 12% + (I don’t think 40% is the norm unlike the last few years). If one can find and invest in good companies, one’s with strong competitive advantage and pricing power, then I think the returns will definitely be more than inflation. Ofcourse in the short run one can lose money, so equity is not hedge against inflation in short term.

2. Debt is usually a component of one’s portfolio. In period of rising inflation it makes sense to invest in floating rate funds. That way one is hedged against inflation and may get a return of 1-2% above inflation. However with the current lose monetary policy and low interest rates, the real returns from such funds may be negative. It is likely that the benchmark rates will be raised in response to the inflation. In such a scenario, floating rate funds may give returns slightly above inflation.

3. Avoid long term FD’s and such commitments. If you invest for 5 years at say 8%, and if inflation crosses 9-10%, then you are losing money. One option can be to break the deposit and re-invest, but there is generally a penalty and loss associated with it.

4. Real estate is good hedge especially if funded by a fixed rate loan. In hindsight 2003-2004 was a great time to invest in real estate. Interest rates were low, everyone thought inflation was gone and real estate seemed to be priced reasonably. However I am not sure how good real estate is now as an investment option in general.

5. Be good at your job/ profession etc . Now this is a non-financial advise, but in the end for most of us the biggest asset is our skills. I think constantly upgrading skills and doing well in our professions is one of the best hedges against inflation. If you are one of the top performers, you will earn more via better increments or higher profits from your business. So I think investing in yourself is one of best hedges against inflation.

Now a lot of people will say gold, metals etc. I personally have no interest in those options. The long term data in most of these options show that the returns track inflation. So in absence of some special understanding of these alternative asset classes, I prefer to avoid them. I think there is enough for me to do in equity and debt than to worry about all this other stuff.

Finally, I mentioned profit from inflation ..is that possible ? if you can fund a long term asset such as real estate with a fixed debt (when rates are low) then during inflationary periods the rental rises with the inflation whereas debt is fixed. So equity in the asset is rising faster than inflation.

Also if you can roughly estimate when inflation is peaking, an investment in long duration debt (such 10 year bonds or mutuals) will give good returns when inflation slows (due to repricing of bonds). This happened to investors during the 2000-2003 time frame.

9 comments:

prabhu said...

I strongly agree with point 5. Being good at profession is the best hedge in all season. It not just creates value in you; it takes off your attention from financial market and lets you relax.

Rohit Chauhan said...

Hi prabhu
agree with you on that point. your profession acts as a good hedge for the portfolio too

regards
rohit

VISHNU said...

Hi Rohit,

I dont agree with your point #1 Equity is one of the best hedges against inflation.
As Graham said in Security Analysis, Equity dont give good returns even on the long term basis.
It gives good returns only when you bought at attractive prices + you are holding it for enough time.

Right now Inflation is 9% , so the expected Earning Yield from Equity is 18% (i.e 5 PE)
How many good companies you can find at 5PE now ? I think Indian Markets are still over valued on average basis( you can find few cheap comanies).


By the way , I have read a good book for Risk Arbitrage.(Trade Like Warren Buffet)..

Let me know if you find a good book on Risk Arbitrage.

Regards
Vishnu

VISHNU said...

Hi Rohit,

I dont agree with your point #1 Equity is one of the best hedges against inflation.
As Graham said in Security Analysis, Equity dont give good returns even on the long term basis.
It gives good returns only when you bought at attractive prices + you are holding it for enough time.

Right now Inflation is 9% , so the expected Earning Yield from Equity is 18% (i.e 5 PE)
How many good companies you can find at 5PE now ? I think Indian Markets are still over valued on average basis( you can find few cheap comanies).

Regards
Vishnu

Anonymous said...

Just wanted to illustrate a supporting point for 5....In one of the questions to Warren Buffett, a chap from Zimbabwe asked what should he do in times of such ravaging inflation and political scenario and WEB's answer was on the lines of "You can't do much investing...invest in yourself....become a skilled doctor etc whose needs will always be there"...so there you go...

Prashant

Rohit Chauhan said...

Hi vishnu
maybe i did not state it explicitly, however any overpriced asset whether equity or something else may even be a losing proposition. so equity is not a slam dunk, but if you buy over a period of time , say via ruppee cost averaging then the returns can be decent and will beat inflation.

I could not understand your logic on requiring 18% yield requirement (5 PE), so cannot comment on that.

On your last point, i agree there are overvalued companies. but i think there are enough undervalued companies available too

regards
rohit

Rohit Chauhan said...

Hi prashant
i remember reading the same comment and to some extent you can say that point 5 is influenced by buffett comment. also for most of us the starting capital to invest will have to come from our professions and if we are not good at it, it is unlikely we will have much to begin with

regards
rohit

Mahendra Naik said...

In response to Vishnu' comment, I would like to state that equity is the best hedge against inflation, regardless of the levels you buy at or whether you buy via SIP or lump sum. Only caveat is that your holding period should be 5 years or more. To simplify things take investing in an index fund mirroring the sensex for a horizon of 5 years. You will see that in 95% of all rolling five year periods returns on equity have beaten any other alternative hands down.

Rohit Chauhan said...

Hi mahendra
very true, if you invest in an index fund via sip you will make decent returns.
however i tend to agree with vishnu on the point that overvalued equities may not provide good returns. so valuation does matter ...however if you buy a great company at high valuation then sometimes over the long term returns are decent

regards
rohit