Portfolio Ideas: Managing the risk of high inflation

July 29, 2015

Unexpected increase in prices can mess up your life goal. Inflation risk is the risk of higher-than-expected increase in prices that leads to failure of your life goal. Let’s suppose you are saving for your child’s college education. You assume that tuition fees will increase by 10 per cent.
Based on this estimate’ you decide your savings rate and allocation between equity and bonds. But at the end of the time horizon, you find that college fee has instead increased by 15 per cent. So’ you have ₹1.3 crore in your portfolio’ but you need ₹1.5 crore to meet education costs.
You have a huge shortfall of 20 lakh between your cash requirement and how much your portfolio generated. This is called the investment value gap.
Time horizon
Fortunately, you can moderate the inflation risk and reduce the potential gap. The most important factor driving inflation risk is the time horizon for each of your life goals. For this purpose, we divide the time horizon into three buckets — one-two years, two-five years and more than five years. Goals with a time horizon of one-two years may have low inflation risk. It is uncommon for inflation to increase sharply within two years. You are thus unlikely to have a large gap due to inflation risk.
Now consider goals with time horizon of more than five years. You do face high inflation risk. For, longer the time horizon, greater the chance of experiencing higher-than-expected inflation.
But here, you can moderate this risk. The expected return on equity is typically higher than the inflation rate. So, you can temper the inflation risk with higher returns from equity. But when your time horizon declines below five years, you have to reduce your equity allocation. And that is when your life goal is exposed to high inflation risk. So when your time horizon is between two and five years, you face a high level of inflation risk. This time period is long enough to experience higher-than-expected inflation. Yet, the horizon is not enough to bridge the gap through higher portfolio returns. So, you have to transfer money from another life goal to bridge the gap.
Goal priority
The secondary factor that drives inflation risk is your goal priority — higher the goal priority, higher the inflation risk. Typically, your child’s education fund would be a high-priority goal for you.
That means you will lean towards investing in bank fixed deposits and not equity for the fear of losing your investments. But bank deposits do not beat inflation. So any unexpected increase in price levels can lead to a large investment value gap.
You can moderate this risk by factoring in the rate of inflation that is most relevant to the life goal that you are pursuing, instead of taking the general price level. For instance, for your children’s education fund, consider inflation relevant to education, and thus reduce the risk of actual inflation on education being much higher than the rate you assumed. You should also be willing to contribute more capital to the portfolio as you near the end of the time horizon to bridge the potential gap.
The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in
(This article was published on July 26, 2015 The Hindu Business Line)