Rules Of A Smart Fund Manager Part 6: Inflated Economy, Deflated Returns

Based on our blog ‘7 Rules Of A Smart Fund Manager (That Everyone Should Follow)’, we’re running a week long series spending a little more time with each rule, so you can easily digest each and every tidbit! #SharingIsCaring

Fund managers know to judge investments by the inflation-adjusted, and not the absolute, returns that they generate.

Why? Say you have Rs. 100, and instead of buying 10 packets of chips that cost Rs. 10 each, you put the money in a savings account that earns 10% interest every year. At the end of the year, your account will have Rs.110.

Congratulations! You just earned Rs. 10 for doing nothing! So you decide to celebrate by inviting some friends over. You go to buy some chips, thinking you have enough money to buy 11 packets. But you get to the shop, and you get a rude shock. Each packet now costs Rs. 20, so you can only buy 5 packets.

What happened? While you earned a 10% return on your investment, the economy underwent inflation at a rate of 100%. So, although your money grew in absolute terms, its value went down significantly. You would have been better off investing your money in chips and reselling them a year later (Unless they went stale during that year. In which case, yuck.).

Since we don’t live in Zimbabwe, such massive inflation isn’t likely. To take a more realistic example, the rate of return for Fixed Deposits is around 8% right now. Adjusting for taxes, the effective rate of return can be 5.6% – 7.2%, depending on your tax slab. Inflation has been around 7.5% on average for the last 5 years. So if you’re investing your money in an FD, it’s actually losing value!

6 Inflated Economy, Deflated Returns