The official inflation rate is published as a single value for all urban families. The upper middle class and affluent families are not adequately represented in the consumption basket
Most investors are used to thinking of the growth rate of their wealth in nominal terms. For example, “I got returns of 11.4 percent a year over the last five years.” Some savvy investors have moved to thinking of the ‘real’ rate of return on their investments. Hence, if they make 11.4 percent annually and the inflation rate over the same period has been 4.9 percent, they infer that their real rate of return has been 6.5 percent p.a. This is obviously the more accurate way to measure the growth rate of your wealth because it tracks the real purchasing power of the amount and not just the Rupee value. During periods of high inflation, such real rates of growth may indeed be as low as 3-5 percent p.a., despite nominal returns of above 12 percent – lulling less-informed investors into a false sense of comfort.
Everyone’s inflation is not quite the same!
There is a serious limitation to using a single inflation rate for everyone in calculating the real rate of growth. The consumption basket of different families is quite different. Yet, the official inflation rate is published as a single value for all urban families (there is a separate one for rural households). While most of the lower-income urban households are adequately represented by this standard consumption basket, the upper middle class and affluent families are not.
The following pie chart shows the standard consumption basket used in calculating the official Consumer Price Inflation in India – shown against the consumption basket of a typical upper middle-class household. Note the increased allocation in the latter to education, recreation, EMIs and clothing, and decreased allocation to food and transportation. As one goes further up the income ladder, one can see even more skew towards recreation and education and away from food.
Given that the overall inflation rate is a weighted average growth rate in costs of individual categories in the consumption basket, one is likely to arrive at different rates of inflation simply by the variation shown above.
The following graph shows the inflation in major individual categories over the 2013-2020 period. As one can see, the cost of housing, education and intoxicants has gone up more than that of the general index. In households where these make up larger proportions of total expenditure, the experienced inflation rate over the last seven years would have been higher.
Some categories missing, others represented differently
For the upper-income segments of the society, there are some categories that are not even included in the standard definition of inflation. For example, leisure travel is missing from the standard consumption basket. Likewise, costs of household help and drivers are missing. Other categories are represented differently; i.e., the branded apparels may experience higher or lower jump in prices versus unbranded ones. Similarly, branded/specialty food items may have a price variation at odds with that of staples.
For many households, home loan EMIs make up a large proportion of the expenditure basket, for a fairly long period of time. During this period, they are exposed to interest rate movements since most home loans have a floating interest rate. This is not reflected in the standard consumption basket. On the other hand, for these households, there is no direct exposure to the rise in cost of housing since they live in their own house. Yet, housing makes up 20 percent of the standard basket.
How can an investor guard against higher personal inflation rate?
There are two levels of analysis an investor needs to undertake. In the first, she needs to find out – at least broadly – what her personal inflation rate is. Using the data available publicly with the RBI and Ministry of Statistics on the individual categories of consumption, she can determine the inflation rate history personalized for her by taking a weighted average of the category-wise inflation rate. This should determine the number she needs to subtract from the nominal returns to arrive at the real rate of returns on her own investments.
Second level of analysis is a bit more involved. If an investor wants to hedge against the divergence between her own inflation rate and the standard one, she needs to invest in the stocks of industries that closely track the categories of consumption where she has the largest allocation. For example, if an investor has large expenses in the form of education fees and leisure travel, she can tilt her equity portfolio towards education and services companies, as well as crude oil manufacturers and the hospitality sector. If the costs of education and hospitality jump sharply, her increased exposure to these stocks would protect the purchasing power of her wealth.(The author is Founder, ASQI Advisors – a financial technology company)