PROTECTION AGAINST INFLATION: What to do when inflation is high.

Your 1 lakh in the bank account will devaluate to become 98000 next year. Shocked! well, as inflation will rise by 5% and saving account interest will give a 3% return, you will lose 2%. So it is very important to understand when inflation starts going to 7-8% what should we do?

What is inflation?

Suppose this year price of tomatoes is 10 rupees. Next year this price becomes 11 rupees. So there is the rise of 10% inflation. Inflation can be healthy sometimes depending upon the countries economy. 2-6% is considered to be healthy inflation. 

Why it is required?

Suppose you work very hard for one year and then you asked for an increment next year from your boss. If you do not get that increment then you become demotivated. So there is a need for a raise in salary. So there is a need for rising inflation to keep the country motivated to grow. 

How inflation happens?

Earlier when gold was the currency the countries were allowed to print the note according to the quantity of gold. Suppose a country has 1 kg gold and they printed 100 rupees. Now the price of gold is 100 rupee per kg. The government thought to print more currency in order to create more liquidity and jobs in the market. 10 more rupee was printed. Now gold price will become 110 rupees per KG. So there is a rise in inflation of 10%. This is one of the simplest ways to raise inflation.

Current situation.

This year due to the pandemic government all over the world has started to print more currencies in order to buy the vaccine and to create infrastructures that more jobs can be created. More jobs will give money in hands of people. When people have the money there purchasing power will increase and hence the economy will grow. Within this process, if things get out of control then inflation can go out of control and hyperinflation will be created. So in order to preserve your money you have to do proper investments so that you don't lose the buying power.

What is hyperinflation?

When inflation goes out of control like in Zimbabwe where to buy bread you have to sell your house. In the last 3 years, zimbabwe's government has printed 90% of the total money circulated in the economy. When money went into the hands of financially uneducated people they start putting money in the stock market. As a result, the Zimbabwe stock market gave a 600% return in the last year (left image). Well is Zimbabwe creating Google facebook in their backyard? No, it's shocking how this bubble is created. So it is very important to understand the right investments so that you don't get trap into these bubbles.

 

What is real Investment?

We are giving up a certain amount of buying power now in order to have more buying power in the future. For example, we are investing 1 iPhone money in order to purchase 5 iPhones after 10 years. This investment has increased your buying power.

In the 1979 annual letter of Warren Buffet it was written: "Just as the original 3% saving bond, a 5% passbook saving account or an 8% U.S. Treasury note have, in turn, been transformed by inflation into a financial instrument that chews up, rather than enhances purchasing power over their investment lives, a business earning 20% on capital can produce a negative real return for its owner under inflationary conditions not much more severe than presently prevail."

Inflation can be bad times for business too. Inflation eats away their purchasing power as well. Businesses general need to buy a lot of stuff to keep operating. If this stuff is now all of sudden very expensive they are trapped in a dilemma either they pay the higher price to operate and make less profit or they try and raise the price and hope their sales volumes doesn't shrink because of it. Inflation can also put pressure on interest rates which can make it harder for companies to excess loans or make pre existing loans more expensive to pay off and this makes for investor more harder to find stock that are going to compound our money over time. So what kind of business should we buy ?

Here Mr Buffet suggests "A business which has ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume. A business should have ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with minor additional investment of capital."

Take an example of a software company that is providing service to XYZ company. Software company increases its annual subscription charge due to inflation. can XYZ company switch to the cheaper alternative. No, as going to other software or platform requires its employee to train them and training again comes with a lot of time constraints budget, and more extra cost. So this software company can survive inflation as it can keep on increasing the price of its annual subscription. So look for a company that can raise prices without consequences.

So I would like to end my examples by one of the buffet speech where he explains what should be the protection against inflation.

"Inflation is an invisible tax that only one man in a million really understands and it attacks the people that have had faith in currency the government issued. The best protection and the best investment against inflation are to improve your own earning power and your talents. Very few people maximize their talents and if you would increase your talent they can not tax it while you are doing it. They can't take it away from you. So if you become so useful in your activities, your profession like doctor lawyer or whatever it may be that is the best protection against inflation."

Thanks for reading. For regular updates about the Indian stock market follow me on Instagram at @paisaconsultant.