Tag: inflation-adjusted return

A phone call between two friends leads to a talk about inflation-adjusted returns.

Akhila: What are you up to, Karthik?

Karthik: I was planning to buy a television set for ₹50,000. But I later changed my mind to save and invest that amount to buy a better version next year.

Akhila: I hope inflation doesn’t eat into your returns.

Karthik: What do you mean?

Akhila: A few economists expect inflation to rise going ahead. If that happens, your inflation-adjusted returns can be low or even negative.

Karthik: Can you explain that?

Akhila: If you invest that ₹50,000 at four per cent p.a. in a fixed-income instrument, your investment will be worth ₹52,000 by year-end. Say, the average inflation over the next one year is six per cent and the price of the TV set which you decided not to buy, becomes ₹53,000. Let alone buying a better version, your investment amount won’t be sufficient to buy even the current model.

Karthik: Ouch!

Akhila: Inflation-adjusted returns, also called real returns takes into account the inflation rate while calculating the return on an investment.

Karthik: How do I calculate real returns?

Akhila: You can simply subtract the rate of inflation from the return on your investment. In the above example, the real return on your investment would be -2 per cent. That is, 4 per cent return minus the inflation rate of 6 per cent.

Karthik: That’s pretty simple.

Akhila: The above formula gives an approximate rate of real return. To be precise, you can use the formula — ((1+return)/(1+inflation rate)) – 1.

Karthik: Are there any savings instruments in the market that offer returns linked to inflation?

Akhila: There used to be inflation-indexed bonds but they are no longer available.

Karthik: Equities would give higher returns, right?

Akhila: Equity is said to deliver inflation-beating returns in the long-run. But remember, for the sake of earning higher inflation-adjusted returns, you should not go for investments that do not fit your risk appetite.

Karthik: What are the alternatives in the fixed income space?

Akhila: You can consider floating-rate instruments, coupon rates on which are linked to interest rate movements in the economy, which are a play of inflation as well.

Karthik: I remember reading the Simply Put column in BL Portfolio a few weeks back that talked about floating rate instruments such as Floating Rate Savings Bonds 2020, the PPF and the Sukanya Samriddhi Yojana.