No deliverance in debt

If you are thinking that with the market behaving the way it has been over the past few months, it’s best now to move your investments to the relative safety of debt instruments that will not just shield you and your money from the vicissitudes of the market but also offer guaranteed returns of 7-9 per cent on it, then you aren’t really being wise and perceptive enough. That’s because you haven’t factored inflation into the equation.

You have forgotten that inflation not just makes you pay through your nose for everything—from food to fuel—but also eats into the returns on your hard-earned money. In fact, it actually shrinks the value of your money in real terms and saps its purchasing power. Says Amar Pandit, Director, My Financial Advisor: “With inflation inching towards 12 per cent, people are actually earning a negative rate of return on their investments in debt such as bank deposits and debtbased funds. This is so because the inflation rate has exceeded the rate of return on their deposits.”

Indeed, as an investor, it’s imperative that you look at the real rate of return before investing in debt, and not just at the nominal rate of interest offered by various instruments such as fixed deposits and debt funds, which look very attractive and reassuring in a bearish market.

Let’s consider an example that shows how inflation impacts interest rates and how the real rate of return is calculated. Suppose you deposit Rs 100 in a one-year fixed deposit scheme at 9 per cent interest per annum. At the end of one year, you will get Rs 109, of which Rs 9 is the interest income. This is the nominal return on your investment after one year. The real rate of return is calculated by deducting the rate of inflation from the nominal interest rate. Assuming that the inflation rate is at 11.9 per cent, your real rate of return would be negative, that is 9 minus 11.9=-2.9 per cent. Says Gaurav Mashruwala, Certified Financial Planner, ACE Financial Advisory: “What’s worse, the impact of tax on your investment returns will send that number further down the negative scale.”

As you would have understood by now, debt is an absolute no-no in the current scenario of high inflation. Instead, if you are planning for the future, it is worthwhile to consider allocating some portion of your portfolio to growth-oriented investments: assets that have the potential to increase in value relative to inflation over the long term.

Says Pandit: “The best way to beat negative returns is to move your portfolio away from low-yielding fixed-income instruments like bank fixed deposits towards assets that offer a better rate of return. It has been observed that the returns on equity and equity-linked instruments have typically beaten inflation by a substantial margin over the long term. Also, if you do invest in fixed-income instruments, choose tax-efficient avenues like FMPs (fixed maturity plans) and mutual funds.”