I recently checked the dictionary definition of investing. One of the best I could find was ‘Investing : to put (money) to use, by purchase or expenditure, in something offering potential profitable returns, as interest, income, or appreciation in value’. Most other dictionaries have a similar approach to investing. It seems obvious, at the time of defining investing, people were not sensitive to the influence of inflation on investing. If the same people who wrote this definition had witnessed some recent happenings, they may have changed this definition.
Take the case of US for example. The S&P 500 hit a peak of about 1550 levels in 2000. Over the past 12 years, the Index is more or less at the same level. As per traditional definition, investors have not made money nor lost money. Whereas, the cumulative inflation over the past 12 year has been 36.6% (averaging 2.6% per annum). As a result, if one had $ 100 in 2000, the true purchasing power of the $ 100 is only $ 73 at the end of 2012. Essentially, though one has not lost money in equities, one has lost 36.6% post inflation.
In India, the story is a bit more scary. Over the past 5 years, consumer price inflation has been averaging 10% per annum. This would mean, if you had Rs 100 five years back, the true purchasing value of the same today would be Rs 62. Even if you had invested in assets that gave you a post tax return of 10.4% per annum, the true purchasing value of the same would be Rs 100 only.
In this context, a wise investor can do one of two things. Firstly, pray to god that this beast called inflation gets tamed sooner than later. Secondly, find out the smart way to generate real returns after inflation.
We do know with certainty that investing in fixed income instruments would not be able to achieve this goal. For example a bank deposit gives you a 9% annual return, but post tax it gives an annual return of only 6.3%. Compare with the inflation rate of over 8%. The investor is certain to lose on purchasing power every year. Real estate, on the other hand, has historically given inflation adjusted real return over time. Of course, one needs to ask whether the current valuations of most real estate in India provides adequate margin of safety – also liquidity will continue to be an issue with real estate.
We like equities primarily because the underlying companies we invest in have the ability to pass on the inflation to their customers. As a result, the underlying assets are priced post inflation. One can therefore say with fair confidence that one should make a reasonable return ahead of inflation over time. Investing in proven business models, which have the ability to pass on cost inflation to their customers, and buying them at sensible prices is definitely one asset which can give you real returns over and above inflation.