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You cannot beat inflation even with equity mutual funds: here's why

Investing in a mixed portfolio of equity and debt mutual funds cannot beat inflation in most cases

You cannot beat inflation even with equity mutual funds: here's why


Posted on 29 Jun 2021
Author: Sayan Sircar
4 mins read
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Investing in a mixed portfolio of equity and debt mutual funds cannot beat inflation in most cases

Inflation cannot be beaten with mutual funds

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Equity mutual funds are widely considered to be able to beat inflation over large periods while debt as an asset class does not. But even by investing in equity funds, it may not be possible to beat inflation at all.

For any long term goal, the asset allocation will have a mix of equity and debt. Also, to manage the risk of the portfolio over time the equity component has to be reduced over time as per the right glide-path via rebalancing. Both of these effects (a mix of equity and debt and maintaining a glide-path via rebalancing) together makes it very difficult to beat inflation over the entire duration of the investment.

Related:
Inflation: the impact on your goals and how to choose assets that beat it

Asset allocation for goals

Asset allocation

As discussed in this detailed post on asset allocation, a typical proportion of long term goals will be like this based on the risk profile of the goal and the investor. We will assume the Medium risk profile for the example in this post.

Rebalancing as per glide path

Rebalancing via glide path

This post on glide-path describes how the equity portion of the portfolio is gradually brought down over time to manage risk via rebalancing.

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A worked out example

Table of returns

This table shows the calculation of effective return using the Medium asset allocation and average equity and debt returns of 4% above inflation and 2% below inflation respectively. This is deliberately chosen to not distract this analysis with assumptions of long term equity and debt returns. The columns show

  • Passage of time in years
  • Equity and debt proportions for each year of the goal
  • Weighted average return for the particular asset allocation for that year
  • Real returns (Return-Inflation) for 3 types of investments: lump sum, a fixed SIP, a SIP increasing at 10% a year

Example

We use the table above to work out on case where a 10% incrementing SIP is created for 10 years. The corpus grows like this:

  • Year 1, SIP 1 lakh, 5% return, starting amount 0, ending amount 1.04 lakhs
  • Year 2, SIP 1.1 lakh, 5% return, starting amount 1.04 lakhs, ending amount 2.25 lakhs ….
  • Year 10, SIP 2.36 lakh, 6.8% return, starting amount 16.81 lakhs, ending amount 20.09 lakhs

We use the last column of this table to calculate IRR which comes to 4.83%. With a 7% inflation assumption, this works out to a real return of -2.17% which is there in row 10, the last column of the table under Real Return: 10% incrementing SIP. AS this table shows, with these starting assumptions (7% inflation and equity/debt returns) we need to invest for:

  • Case 1: 22 years to beat inflation for a lump sum investment
  • Case 2: 29 years to beat inflation for a fixed SIP
  • Case 3: 40 years to beat inflation for a 10% incrementing SIP

Conclusions

Case 1 shows that a long term lump sum investment (say a gift for children’s education) needs more than 20 years to beat inflation with 60% starting equity investment

Case 2 shows that a standard SIP does not beat inflation before 30 years. This will come as a big shock to many investors who believe that starting a SIP will beat inflation over time.

Case 3 shows the same result but due to an incrementing SIP, a larger amount is invested near the end of the goal which has a more conservative portfolio.

The key takeaways for investors are

  • not assume that investments will beat inflation at reasonable levels of risk
  • positive real return during retirement is not possible
  • investments should be as high as possible as per the plan of investments - this is the only way to meet long term goals
  • review and rebalancing is essential to manage risk

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This post titled You cannot beat inflation even with equity mutual funds: here's why first appeared on 29 Jun 2021 at https://arthgyaan.com


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