Inflation eats into the returns you get in low risk investments. All investment advisors will tell you this again and again. It has been told so often that all laymen accept it as the truth.

Low Risk Investments are the Best Hedge Against Inflation

The reality is however quite different – in fact it is the opposite. One of the reasons why low risk investments are considered low risk is that low risk investments are the best hedge against inflation. There is a much better chance of beating inflation by investing in low risk investments as compared to investing in high risk investments.

High Risk Investments are Volatile

High risk investments are considered risky because the returns from them is volatile. That is to say that the return keeps fluctuating from period to period. In one year or in one month they go up and after some time the returns go down. When the returns fall, the gains made when the returns rise are wiped out either in full or in part.

Example of Volatility and its affect on returns

For example if a share price is Rs.100 at the time of purchase and next year it falls by 10 %, the share price is now Rs.90. In the second year it rises by 8 %, and the share price is now Rs. 97.20. In the next year it further rises by 5 % and the new share price is Rs. 102.06. In the fourth year it drops by 6 % and the share price is now Rs.95.94. In the fifth year the share price rises by 15 % and the fifth year share price is Rs. 110.33. In five years the total return to the shareholder is Rs. 10.33 or an increase of 10.33 % over a period of 5 years.

Example of steady flow of return – not volatile

Suppose the same investment had been made in a bank deposit giving say 6 % rate of interest Rs.100 invested would fetch the investor after 5 years Rs. 100 compounded annually for 5 years which is Rs. 133.82. That is a return of Rs. 33.82 over a period of 5 years

Investments with a steady flow of return are more likely to earn a high income in the long run as compared to investments in high risk

Now which investment is giving better returns? Compare Rs. 10.33 earned in a share and Rs. 33.82 earned in a bank. Remember volatility kills profit, that is why shares and mutual funds are considered risky.

How is the Rate of Interest Determined in The Economy

Coming to inflation and its effect on investment returns. Let us understand how the rates of interest are determined in an economy. One of the rates, called the Repo Rate, is the chief determinant of all interest rates in an economy. The Repo rate is the rate at which the RBI lends to the commercial banks. The RBI determines the Repo Rate. The banks decide their rates of interest (whether saving or lending) based on the Repo Rate. An increase in the Repo Rate leads to an increase in the bank rates and a decrease in the Repo Rate leads to a fall in the bank rates.

The rate of interest in the long run can never be less than the rate of inflation

There are many factors which go into the calculation of the rate of interest. One of the factors is the rate of inflation. The RBI increases the Repo Rate if in the opinion of RBI the rate of inflation is likely to rise. Conversely, the RBI reduces the Repo Rate if the RBI expects the inflation rate to fall. In this scenario the Repo Rate (and as a consequence the savings and lending rates) will always remain more than the rate of inflation in the long run.

In the equation where 3+2=5, for example we can never say that 3 or 2 is greater than 5. Similarly with the rate of interest. Since the rate of interest is calculated by RBI based on the rate of inflation, we can never say that the rate of inflation is more than the rate of interest.

In the short run it may be possible for a short period

However in the short run, it is possible that the rate of inflation is greater than the rate of interest. This is because when the rate of inflation rises, it takes time for the RBI to consider the same and raise the rate of interest. Usually there is a 3 month time lag.

In the long run however the rate of inflation will always be less than the rate of interest on low risk investments.

There is no connection between the rate of inflation and rate of return on a high risk investment

The same cannot be said about high risk investments. There is very little relation between the rate of inflation and return on high risk investments. The notion that high risk investments will give the investor more return is based on the assumption that high risk investments will always give you high returns. This however is not true. By nature and by definition a high risk investment may or may not give you high return. As we have seen above the principal reason for this is volatility.

Advisors fraudulently play on the sentiments of the investors by misleading them that high risk investments will always give higher return

This is another way in which financial advisors fraudulently convince investors. They feed the investor with stories of how a lot of money can be earned in high risk investments and if by chance in the short term, the rate of inflation is higher than the bank fixed deposit rate (at a given time), they show how much the investor is losing by investing in low risk investment. The fact not told to the investor is that the rate of inflation being higher than the rate of interest is essentially a short term phenomena and it does not affect long term investments in low risk investments, is not mentioned. Gullible investors fall for this sale pitch and are led by the financial advisors to take risks in investments, even if by nature they are risk averse.

In my next article I will present actual data from RBI and Ministry of Statistics to further prove the point mentioned in this article. In the meanwhile

Sell Risks and Not Returns