Hedging against inflation

Suresh Krishnamurthy

IN A paper titled ``A framework for analysing and managing retirement risks'', authors Olivia S. Mitchell and Zvi Bodie urge investors to consider the factors of hedging, insurance and diversification while investing for retirement.

While this suggestion was made with reference to the developed nations, it is also applicable to investors in India. Indeed, investments need to be made with a view to hedging against inflation, must include insurance, specifically medical insurance, and most important, must be diversified.

Hedging against inflation in India is a tough objective. Investors do not have access to innovative financial products such as inflation-linked bonds. Investing in stocks is an option but, in the short-term, investing in stocks has proved quite unreliable as an hedge against inflation.

In the past six out of nine years, including this financial, stock prices have fallen when inflation increased. In some years, the downtrend was particularly severe. Soaring inflation in these years coincided with a sharp downtrend in stock prices.

In such a backdrop, investing in stocks as a hedge against inflation needs to be an objective without any particular tenure in mind but with the ability to hold for a longer term if the need arises. Investments also need to be made with particular targets in mind. As and when such targets are achieved, the profits must be cashed out and invested in fixed-income investments.

For example, investors can book profits every time the Sensex surges past an all-time high or past a fixed annual percentage gain. Investors should not worry about a possible loss in profits. They have to keep their objective in mind, which is hedging their portfolio against inflation.

For investors whose risk-preference would rule out investing in stocks, the only option to hedge against the inflation is to set aside a portion of the proceeds in a cumulative investment option even after retirement. This would enhance the retirement wealth over a period to adjust for the rise in inflation then.

Similarly, medical insurance is an option they cannot but consider. There are a number of policies from insurance companies that seek to address the needs of investors. Depending upon his health and hereditary trends, an appropriate policy would have to be selected. Given the complicated nature of these policies, advice should be sought from those familiar with them to ensure that one are neither over- nor under-insured.

Diversification of the portfolio is essential to ensure that investors are not caught off-guard by factors such as the interest rate risk. Investing in equity, as in fixed-income instruments, comes with its own risk. For example, an investor who invested in 1996 at an investment rate of 16 per cent plus in a five-year deposit would now have to contend with the dreaded reinvestment risk as interest rates have now come down to less than 12 per cent on quality investment options.

For a retired investor dependent on retirement wealth to generate regular income, this is a horrifying phenomenon considering the rapid pace inflation has maintained during these years. However, if investors had in 1996 diversified into options such as mutual funds, the impact of the decline in interest rates would have materialised into a gain in the value of mutual fund investments, and the magnitude of the problem would not have been as large.

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Preparing for uncertainty

Even after careful planning, investors may not be assured of carefree retirement. This is because of the enormous uncertainties that are involved. Income, expenditure, taxes, inflation and the return on investments are all subject to change.

An investor need to be prepared for such uncertainty. And as when material changes take place, the original plan has to be amended to ensure that there is still no shortfall in incomes during the retirement period. Constant hands-on planning and investing is a necessity, and investors have to either do this on their own or with professional help. Those who can afford little risk in these issues would be better off considering professional help.