When you get your first paycheck, first word of parents’ advise you receive would probably be to open up a fixed / recurring deposits. And its very common, 99 out of 100 parents’ “go to” gyan for where to put our money would be FD/RD. Of course, why wouldn’t they? It’s only practical as it not only offers marginal returns but also offers surety of money. No one wants to lose their money, do they?!
Most common aim of investing would be to not lose our capital. Knowingly or unknowingly, this sets the tone for all investments. Investors tend to stay conservative in their approach by putting their funds in debt or fixed income securities (FD / RD).
They would rather accept less returns than losing their hard-earned money. That’s completely acceptable of course. But caveat though is that one should not put entire investment amount in such instruments. Let me explain you, how this is a very dangerous yet common practice.
Losing your purchasing power
In the long run, by investing only in such instruments, you end up not only losing out on higher returns (read opportunity cost) but your capital also gets eroded. Isn’t that a shocker? Losing money? In fixed instruments? You probably are wondering what we are smoking. Believe me, we aren’t kidding, your capital might erode even in fixed instruments. How?!
To understand that, first you need to get hold of what purchasing power means. It is the value of a rupee expressed in terms of the amount of goods or services that one rupee can buy. Or simply put, with same amount of money, what amount of goods can you buy. And FYI, inflation is the villain to your purchasing power.
For example, you probably heard your mom quip “When we were young, I used to buy 1 litre of milk and a “mango bite” for ₹10, now it costs ₹ 58″. or your engineer father claiming his first salary was ₹4,500 within which he ran your entire family. With ₹4,500 today, you would find it difficult to manage for a week let alone a month. This is because of inflation (and CPI).
So, if the year on year returns on your investment does not beat the inflation, the value of your money gets depreciated. And these debt instruments often do not beat inflation since the returns are fixed and guaranteed. So, investing only in debt instruments will significantly impact the amount which you gain in the long run.
In other words, you will be able to buy lesser with the maturity money from these instruments than when you began investing. You must diversify your investment in various asset classes like equities or commodities to get the inflation beating returns. A fair word of caution, the risk factor is also higher in such investments.
You probably are wondering still how investing in fixed instruments erodes money? Still a bit confusing, isn’t it? Allow us to illustrate.
Let’s say that you have ₹1,00,000 with you. Assume the needs which you can satisfy with that amount remains the same. As mentioned, the value of ₹1,00,000 will depreciate over the period due to inflation.
Let’s give you a picture of how purchasing power of initial money ₹1,00,000 in 2010 would be in 10 years. Imagine you locked this money up in your cupboard and are taking it out after 10 years. Due to inflation, the purchasing power of it is equivalent to just ₹48,000 in 2020.
Effectively, with your ₹1,00,000, you would only be able to buy goods which would have costed you just ₹48,000 in 2010. Considering the inflation rate, to hold the same purchasing power of ₹1,00,000 in 2010, you must have ₹1,95,863 today. So, your investment value at the end of 10 years must be at least ₹1,95,863 to maintain same purchasing power.
Forget about capital appreciation, to just retain the same value of money you had, you must target this. In other words, you have just ~50% of money to cover your needs (assuming you have same needs). This is capital erosion by inflation.
Asset class return comparison with Inflation
So, now you understand the importance of beating the inflation. To check how return would be with respect to inflation, we compared fixed income with equity linked variants of mutual funds. For fixed return we considered an average return of 6% year on year.
For mutual funds, we listed all available mutual fund in all major categories along with its 10 year return using Valueresearch fund analyzer (it is something you should definitely checkout, it has awesome tools of comparison of all available segments of mutual funds). We considered the 10th highest return giving fund in all categories. Why 10th you ask?
Quite simple actually, first and foremost it is improbable to accurately predict best performing fund 10 years prior. maybe the best fund did something unique and is a market leader. Finally, it is very probable to predict one of the 10 best performing fund in a category. All it needs is some initial research and some very preliminary analysis.
The results were quite damning. If you go for investing in fixed securities or small cap mutual funds, you would at best just about retain the same purchasing power. However, if you invest in mutual funds (except small cap), you handsomely beat inflation and grow your capital. You will have a higher purchasing power than what you had 10 years ago.
A word of caution, however, you can’t take returns for granted just because you invest in mutual funds. As small caps serve you, you have to invest in right mutual funds. This brings into question about how to choose the right mutual fund which we will discuss in detail some other time.
In conclusion, don’t settle for conservative returns in the name of capital protection. If you don’t take enough calculated risks, you eventually end up doing it. Like it or not, you can mark our words, inflation is coming at you. Be ready and protect yourself by just being smart.