Adding to your risk quotient by changing investments for more returns is not advisable.

These days, the real rate of return, which is the return net of inflation, has become all the more contextual. The consumer price index or CPI-based inflation has been consistently higher than 6% since the beginning of the calendar year. The interest rates offered by banks and other deposit-taking institutions have eased, and real return has been negative for some time.

You must have heard earlier that when inflation is higher than your return on an investment, you are losing money, which means that inflation is eating into what you are apparently earning. That theory is correct. However, don’t take the negative real return to heart and don’t let that change the way you make your investment decisions.

Let me give you a counter-argument. If you were to change your investment decision because your portfolio is giving negative returns, pause for a moment and ask yourself: what is this “inflation” that is driving your decision? You would say, increase in prices and effective reduction in purchasing power. Yes, but how is it measured? It is measured for a basket of items. However, it is the same consumption basket for everybody, irrespective of the profession, earnings, consumption patterns, age, gender and location, among others. This is for administrative simplicity.

You will appreciate that the consumption basket of a 50-year-old CEO in Mumbai will be different from that of a 25-year-old artist based out of Kolkata. That of a 35-year-old software engineer living in Bengaluru will be different from the basket of a 43-year-old taxi driver in Delhi, which again will be different from what a 75-year-old retired senior citizen in Chennai has.

However, the data point of 6.69% of CPI inflation (the latest declared data for August 2020) is supposed to influence the investment and perceived real return of all these people. The consumption basket of every individual is different, even within a family. For that declared number of 6.69%, the relevant inflation for your basket could be, say, 4.69% or 8.69%. Hence, it is relevant to keep track of that data point of 6.69%, but it is only an estimate for your basket, and not vital enough for your investment portfolio to change.

The measurement is year-on-year. For August inflation data, the price of the items in the basket is compared with the price as on August 2019 and the rate of increase, 6.69% in our example, is declared.

Sometimes, the prices of certain items shoot up, which increases inflation at that point of time. This, in turn, creates a high base and lowers inflation, next year. You would recall that when prices of pulses or onion shoot up, inflation eases in the corresponding month next year, even if the prices are increasing at a palpable pace. Similarly, if there is bumper production of a crop and prices are easy, it increases inflation in the corresponding month next year. This, in turn, reduces your perceived real return, because in the corresponding month in the previous year, production of one crop was abundant.

For example, monsoon rainfall is measured to declare 10% surplus or 10% deficient against the long-period-average (of 50 years). That is to say, excess or deficient rainfall in a year does not distort the data point next year. As against this, GDP and inflation data points, which we all consume with wide eyes and emotional involvement, and which influences decision-making at the government and at the central bank, is measured year-on-year.

What can you do? You have no control over inflation as such or the measurement of it. But you have control over your own investment decisions. You have control over your consumption as well, but as long as you are not indulging in wasteful or conspicuous consumption, you need not sacrifice on that.

Coming to your investment decisions, in case you are worried about the negative real interest rate, you would increase your risk level, which may not be worth it. For example, instead of a good credit quality bond or bond fund, if you settle for an inferior one, your return goes up, but do does the risk level. Equity has given higher-than-inflation returns over a long period of time.

Having said that, the allocation to equity in your portfolio should be as much as you are prepared for. If you are a 30-year-old earning professional, you may invest ,say, 70% of your portfolio in equity, but if you are a 70-year-old retired person, it should be say, 30%. To conclude, inflation would ease gradually from this point, as supply bottlenecks are opening up and a high base is being created for next year. So, take heart.

Source: https://www.livemint.com/money/personal-finance/do-not-alter-your-investments-due-to-inflation-rate-11600704283213.html