BEGINNER'S GUIDE TO INVESTING
Inflation

Basics

Inflation is the rate of rise in the general level of prices. It is measured by the changing cost over time of a “basket of goods and services” for a typical household. In other words, the rate of rise is calculated for multiple things and services and an average value is provided. Important phrases:
  1. 1.
    Rate of rise- it is a rate of rise (like in physics, it is rate of change of velocity aka acceleration). So, even if inflation rate is getting down (like in the past few months), the rise may still be there. Only when the inflation is 0% or negative will the actual prices be stable or go downwards.
  2. 2.
    Basket of Goods – The price of some goods may rise while those of others may fall, so an average weighted value of increase (or decrease) is calculated officially.
  3. 3.
    Typical household – Presently, there is a typical rural and a typical urban household which have different weightages to individual components.
The weightages in CPI are as follows:
Sub Group (New CPI)
Rural
Urban
All India
Food, beverages and tobacco
59.31
37.15
49.71
Fuel and Light
10.42
8.40
9.49
Clothing, bedding and footwear
5.36
3.91
4.73
Housing
0.00
22.53
9.77
Miscellaneous
24.91
28.00
26.31

Types of Inflation Indexes:

  1. 1.
    Wholesale Price Index (WPI) - this is the index of the prices of a basket of goods and services at the wholesale level. For practical purposes, this is useless for us. Although, it can be considered as a leading indicator (=leading means it will move earlier than CPI).
  2. 2.
    Consumer Price Index (CPI) – this is the level at the end-consumer level. This has 3 subtypes- Rural (for the typical rural household), Urban (for the typical urban household) and Combined.
Implication of Typical household: Like any average across things with vast variance, a “typical household” would usually be very different from a particular household’s experience. In case, your own expenses are 40% towards rent, 20% towards food, etc. instead of the 22% and 37% of the official typical urban household, your net total inflation would be different from the official CPI figures. By choosing to change the weightages, you can influence the inflation applicable to you.
Therefore, CPI has to be looked for the trends and an approximation of the inflation, rather than directly applicable to you. For accuracy, you would have to take into account your particular way of expenditure.
Wage Inflation: If you think that your salary (or income) should increase every year by 10%, then you can expect the overall inflation to be in that region too. While, if you see that the overall wage increase is pretty low or non-existent, the overall inflation would tend to be lower. Wage increase comes under the Services section as mentioned above. This is true for an average point of view. Some sectors may have higher wage inflation while others may have a lower one. The important thing to remember would be that if your Wage increase is higher than your household’s particular inflation figure then you are ahead.

Implication for Investing

Inflation acts as a treadmill. If an investment is not running at the speed of the treadmill, it will start lagging. The larger the difference, more will be the lag. Another way to visualize Inflation is to think of it like a Negative Rate Bond and has to be applied to every type of investment / savings scheme. An 8% return with an inflation rate of 8% means that the investment is running exactly at the speed of the treadmill. So, you may be running fast but your overall movement to an outside viewer is Zero. Applying the negative bond way, the net Real Return is 8%-8%=0.
Real Return = Nominal Return minus Inflation, where Nominal return is what is told everywhere. And the real return is what is really applicable.
For very long periods of time, the following has been observed (it may or may not hold in the future though).
Asset
Real Return
Nominal Return with Inflation @ 8-9%
Nominal Return with Inflation @ 1-2%
Cash or Liquid Funds
0-0.5%
8-9%
1-2%
Long Term Bonds
1-2%
9-10%
2-3%
Equities
3-4%
11-13%
4-5%
In the short and medium terms, all these returns can be very irregular (better term is Volatile).
Inflation tends to inflate the nominal returns of most asset classes in the long time frames. In periods of high inflation, all the asset classes produce higher nominal returns. And in lower inflation, asset classes tend to produce lower nominal returns. You should always be concerned about the real returns.