Try debt as short-term inflation hedge, but turn to equities for long-term bet

We are in unusual times, spending a lot of our time and energy tracking inflation, besides the US economy, global equity markets, domestic bond yields, crude, and gold prices, among others. This obsession with inflation is not unfounded: it is an outcome of the incessantly high inflation, which took us by surprise last year, when the year-on-year WPI inflation reached 8.86% in January 2010.

In fact, on a month-on-month basis, the wholesale price index has inched up for 28 months at a stretch - since February 2009, when it was at 123.3, to 153 in June 2011 - an absolute rise of 24% in 28 months.

For our investments, we always look for avenues that will give us the highest real returns, ie, nominal returns less the prevailing inflation rate. In other words, inflation is one of the "causes" of the return we get on our investment. But, in the current unusual circumstances, inflation has in a way become an "effect", ie, we are now compelled to choose those investments that will help us at least cover inflation, if not beat it.

All investment asset classes can be broadly divided into two segments: a) Those that will help us grow our wealth, and b) those assets that will help us at least beat inflation marginally so that our wealth does not erode. In the first category, which I would term as growth assets, I would include real estate, equity and art, going by the past decade's data available on International and Indian markets.

Data relating to the Indian stock market since April 1979 show that Sensex has given a return of 16.4% over 32 years, against the average inflation of 7% during the period. This translates into a real return of 9.4%, which means that 1 lakh invested in 1979 would have become 1.29 crore today in nominal terms.

And please note that this amount is 1.2 crore more than any other investment you would have made, which would have given return equivalent to inflation. In other words, your "net wealth" would have grown by the above amount, justifying the tag of growth asset, which equity has proved to be.

The returns in other growth assets like real estate and art are equally impressive over the long term.

Other popular asset classes that help you beat inflation are commodities (mainly gold) and debt schemes. Most investors are happy to simply get 1-2% returns more than the prevailing inflation, because their time horizon of investment is short (say 1-3 years), or they do not want to take on the psychological pressure associated with the erosion of capital in short term.

At present, inflation is on the verge of hitting the double-digit mark, and there are plenty of debt schemes like fixed maturity plans (FMPs) of mutual funds yielding approximately 9.5%, 3/5/7-year NCDs and bonds yielding returns in the range of 10% to 12%, and corporate deposits giving 11-12% per annum over two to three years. One can, therefore, try and benefit from inflation arbitrage.

In all probability, inflation is likely to peak in the next 1-2 quarters and should be around 6-7%, or even lower, by the end of this fiscal year. Once that happens, interest rates should also peak out, thereby making this an ideal time to lock in money at high interest rates for a period of 2-3 years, so that when inflation begins to ease in say six months from now, you would enjoy an extended period of very attractive real returns.

Commodities such as gold are considered good investments at the start of an inflationary cycle, but not towards the end of it. Even the global commodity prices are showing a weakening trend in the light of the anticipated slowdown in growth in the developed as well as developing economies. In such an environment when incremental demand is likely to decelerate, commodities are only expected to moderate.

Investing in them for the purpose of hedging against inflation can be counterproductive at this point in time. Having said this, gold has continued to surprise everyone, giving a return of 21% per annum over the last three years. Optimists continue to expect high double-digit returns from gold in the coming years due to the continuously high global risk.

To conclude, it is important to recognise the phase of inflation cycle we are in, before deciding upon an investment that will help us beat inflation. Based on the present situation, it is better to benefit from the potential of "inflation arbitrage", apart from focusing on growing your wealth in real terms over the long term.

So, debt investments for a period of 1-3 years (for inflation arbitrage) and equity investments for long-term wealth creation (3 years or beyond) seem to be the ideal combination for investment