Inflation v/s Volatility – It is risk now or later!

Mr. Iyer made very clear to his investment advisor that he does not like taking risk. A normal thought that would cross any advisor’s mind when an investor states what Mr. Iyer said is either that the investor does not want to risk his capital and wants to ensure that his capital remains intact or the second thought is that the investor does not want to face the risk of running out or falling short of money when he is nearing his financial goal. While a lay investor might struggle to put both the above in perspective, reality is there can be vast difference in perseverance of risk.

When normally an investor opts for so called safe investment avenues such as fixed deposit, he is protecting himself against the risk of volatility. He seeks comfort under the disguise shelter of safety of capital. However at the very same moment he is risking himself against the risk of losing out to inflation in the long run. His investments earn negative real rate of return. This means he may not have enough money to fund his long-term financial goal.

Most investors cannot withstand transparency. When they invest in equity market, they can literally see value of their investments rising or falling based on market condition. Volatility scares them and they find equity investing risky. In case of fixed deposit they do not see the hidden inflation, which is eroding actual value. They can only see that their principal has remained intact. Therefore they believe their investments are free of risk.

Inflation is much larger, long term and hidden risk compared to volatility. Volatility is transparent. Also over a long period of time impact of volatility reduces.

Whenever an investor decides to seek shelter from risk, he should make himself specific. Does he want shelter from volatility and hence he is seeking protection of capital or is he willing to face volatility in short term but in the longer run wants to ensure that his corpus outgrows inflation and that he has enough to meet his financial goals?

Following table shows value of Rs 1 lakh, if we were to get 4% p.a. less return than inflation i.e. 4% p.a. negative return.

We notice that as time increases the actual value of Rs 1 lakh is eroding. Longer the money stays in an avenue that is losing to inflation more risky is the investment.

On the other hand, the following table shows value of Rs 1 lakh, which is only generating 4% p.a. over and above rate of inflation.

Mere 4% p.a. positive or negative return can generate drastically different results.

If we are saving for a financial goal that is less than 2/3 years away opt for safety of principal - even if it means losing to inflation. On the other hand if you are saving for financial goal which is more than 7/9 years away go for appreciation even if it means withstanding volatility in near term. For an interim goal invest in both kinds of asset classes.

- Gaurav Mashruwala

The author is a Certified Financial Planner. He may be reached at gmashruwala@gmail.com

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