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Is equity the best asset class to beat inflation?

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Depending on the risk profile and time horizon of an investor, asset allocation within equities across market caps can be done to generate alpha

INTEREST rates are fabulously up. From a meagre 3.5 per cent in my savings account I can manage to garner 10 per cent gross in an ultra short-term fund and 11 per cent pretax in a bank fixed deposit. Even marquee banks are stepping up and offering 10 per cent for a long period of time.

So why should an investor even look at equity markets? Well, if you compare these debt returns with the inflation, it is largely negative. So most of the real interest rates offered by the market are negative even now and may not stave off inflation, barring the recent domestic liquidity crunch, which has led to higher interest rate offerings. So for investors with financial goals in future, the cost of acquisition of these will go up, thanks to inflation.

Consider this: domestic equity markets have given 16 per cent average re turns in the past decade with average inflation being 7 per cent. Thus, stock markets have consistently kept pace and beat inflation. And this is just with the benchmark market returns.

Depending on the risk profile and time horizon of the investor, asset allocation within equities across market caps can be done to generate alpha, which may exceed the aforementioned returns.

This is not to deny the advantage of debt funds in any investor's portfolio.

Far from it, it is our belief that a sensible portfolio would be like a "thaali", wherein you have a mix of equity, debt, commodities, insurance and real estate.

What I am underlining here is the fact that an equity flavour would infuse an added push to overall portfolio returns, which may exceed inflation.

Let's look at it from another angle.

When an investor is investing in equity market, what he/she is doing is buying a part share in the business of that company. So if I am buying one share of Infosys, it means I am a part owner, however small that might be! When people do business, they invest in projects or work with a target of making returns which should sizeable be in excess of their invested capital cost, in other words, the IRR (internal rate of return) should exceed cost of capital, which is nothing capital, which is nothing but a weighted average of debt cost and cost of equity.

So, a good company would earn IRRs in excess of cost of capital on a fairly consistent basis. This, in a way, beats inflation. We as investors are investing in such companies to garner growth and beat inflation.

To sum it up, depending on the risk profile of the average investor, the overall portfolio should be carved into debt, equity and other asset classes.

This allocation can also change in the interim depending on market conditions.

With regards to equity, the best vehicle to own the market for the uninitiated investor is investing through the mutual fund route with index funds, which can provide him/her market returns, thereby reducing dissonance.

If the investor is reasonably savvy and aware of risk return implications, he/she can venture into other mutual fund products and also invest directly in equity.

Happy Investing!!

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You can write back to us at PrajnaCapital [at] Gmail [dot] Com

 

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