Inflation - Part 3 of 3

Inflation rate refers to a general rise in prices measured against a standard level of purchasing power. The most well-known measure of Inflation is the CPI which measures consumer prices.

The Consumer Price Index is a measure prices of a list of goods and services purchased by a 'consumer'. The inflation rate is the percentage rate of change of a price index over time (typically 1 year). The list of items which are part of CPI are
• Food (this group has 8 sub items)
• Non Food like Pan, Supari, Tobacco and Intoxicants
• Fuel & Light
• Housing
• Clothing
• Miscellaneous

Due to excessive money in the system (‘Quantitative Easing’ in US, the printing of free money in US and EU) costs of basic items of consumption have increased. Also, due to the economic growth of India, levels of affordability of Indian consumers has also increased (look at the crowd at Indian malls!!!). Today more and more Indians are willing to spend higher as compared to few years ago on consumption items which are both a necessity and luxury.

The ‘young, working population’ of our country (now seen as the biggest asset of India) spends more than it saves. ‘Saving’ for a rainy day was more a habit of my parents’ generation.

Today the motto is ‘Have Money, Will Spend’. So RBI can continue to increase interest rates but if people refuse to save more than they spend, inflation is not going to come down.

PS: Inflation will ease post January 2012 because of the base effect. That’s what all policy makers in India are hoping for (fingers crossed).

Inflation - Part 2 of 3

Inflation reduces the purchasing power.

To control, inflation the RBI (Central Banks) increases interest rates. But how does increasing interest rates help reduce inflation.

Here’s how it works:
One pays interest on loans taken and receives interest on deposits made. To allow lending and borrowing, banks also borrow from / deposit with RBI.

By increasing interest rate, RBI achieves the following:
• Banks need money to lend so they borrow from RBI; if borrowing rate increases, they have to increase lending rates
• Loans become expensive and lesser people take loans
• Deposit rates become attractive so people save more and spend less
• Lesser ‘free money’ in the system
• Cost of items reduces as demand for the item falls (assuming supply is constant)

High inflation in India is not an exception though due to some India specific issues (supply side issues in agriculture) inflation is higher than other emerging countries.

Main reason for the inflation has been high globally is due to the loose monetary measures (keeping interest rates low and QE 1 & QE 2) by countries like US and the EU.

Next part: How’s inflation measured and why is not reducing even after interest rates have been increased by RBI many a times in the last 2 years.

Inflation - Part 1 of 3

With so much of talk about inflation and RBI’s monetary policy, so here’s the low down and again in a multi-part series.

We all know that inflation makes things more expensive, reduces purchasing power, gives enough headaches to governments all around (including being the cause for governments to fall), etc.

Inflation in simplest terms is got to do with ‘supply of money’. It is more money chasing limited items; it’s about people spending more than they are saving.

Here’s an example:
There are 3 friends (Alpha, Beta, Gamma), of different socio-economic backgrounds.
All of them make purchases needed for living (all these items are finite and limited in quantity and are impacted by economies of demand-supply) – fruits, vegetables, fuel, etc.

Let’s take petrol as the item they would like to buy. All 3 friends, by virtue their socio-economic backgrounds will be willing to pay different amounts for the same item.
Alpha has Rs. 3,000/-, Beta has Rs. 5,000/- and Gamma has Rs. 10,000/- of ‘money power’ they are willing to spend. Since the supply of petrol is limited, Gamma has the maximum power of ‘affordability’. The other 2 guys will possibly chose to use public transport :-).

The sheer power of ‘affordability’ makes items expensive for many people.

And why will petrol be an ‘unreasonable’ price in the first place? Remember, a producer of an item (in this case Organization of Petroleum Exporting Countries aka OPEC) will always want to sell at the maximum possible value as long as there are consumers to pay for it.

Risks and the Stock Markets - Part 7 of 7

As I come to the end of this series, my last food for thought – If one can survive with the risk of driving a car, one can very well survive the stock markets.

• Investing in the stock market / stock is very much like buying a car
o Identify your budget
o Do your research before you buy the stock
o Compare it with its peers
o Read reviews of the stock
o Look at historic performance of the stock
o Set your return targets of the stock and time period

• Investing in the stock market / stock is very much like driving your car
o Know your limits of the return on investment from your stock
o Don’t be ‘hands-off’ your portfolio
o One will not get good portfolio managers (just like you’ll not get good drivers)
o Be wary of what others are doing in the market not necessarily follow the herd
o Be cautious of the big vehicles (FIIs) who are also invested in your stock
o Maintain the course and speed; overspeeding (taking too many risks) is sign of desperation
o Bigger the car, higher is the confidence while driving (not applicable to auto drivers)

• Investing in the stock market / stock is very much like maintaining your car
o Review your stock’s performance regularly
o Check your portfolio with a financial advisor (not necessarily me :-)!)
o Sell your stock (just the way you would sell your car) when it reaches its end of fair value

Global Events, Global Markets, Global Euphoria!!

Last time I wrote the below article (barely a month ago!!), it looked like the financial markets were preparing for the worst melt-down in the Financial Markets.

As on Friday, stock markets have given fantastic returns over the 3 week period since September 22, 2011.

Brazil and Indian stock markets have returned 7.2% and 5.2% respectively in the last one week alone.

As in my previous article, even today no one has the ‘probable solution’. So why the elation in asset classes?
Case in point is though EU has cleared a Euro 400 Billion Fund, the total debt in the EU is 6,500 Billion. The EFSF is 6.15% of the total debt of the EU.

The important point to note is that stock markets have very short term memory. No news lasts forever. So don’t try to time to ‘bottom fish’ for good stocks.

Risks and the Stock Markets - Part 6 of 7

Here are the strategies for the various options you identify yourself with:
• Max profit of Rs. 10/- and max loss of Rs. 10/-
o Invest in an index linked mutual fund or an index ETF which gives you 10% returns and inflation reduces your value by 10%
o Net effect money’s value has neither increased nor reduced
o Disadvantage – you’ll never be able to keep pace with the loss in value of money

• Max profit of Rs. 20/- and max loss of Rs. 10/-
o Equity mutual funds (over 3 – 5 year periods) will give a return of 20% pa and inflation will reduce your money value by 10% pa
o This is a FAR BETTER option than PPF, FDs and endowment or money back insurance policies

• Max profit of Rs. 50/- and max loss of Rs. 50/-
o Large market cap stocks which are less impacted by macro and micro economic factors (E.g. FMCG stocks like ITC, HUL – we’ll not stop using toothpaste even if the dollar crashes, petrol becomes unaffordable )
o One needs to have some investment in these companies

• Max profit of Rs. 100/- and max loss of Rs. 100/-
o Penny stock, small market cap stocks (they rise, crash and most of the times vanish!!)
o Don’t get into these stocks
o People with very HIGH risk appetite should try

• Max profit of Rs. 200/- and max loss of Rs. 100/-
o Multi baggers like Hero Honda, Infosys and AirTel [I bought AirTel in 2002 @ Rs. 16, today the price is Rs. 744/- (price adjusted for stock split)]
o Current market provides many a opportunities of companies which will be “Blue Chip’ firms of tomorrow.

The next important rule is to split your Rs. 100 / Rs. 1,00,000/- in a mix and match of the above options. This is called portfolio diversification.

All options linked to the market should be looked as investments for atleast a 3+ year horizon.

Risks and the Stock Markets - Part 5 of 7

Continuing from my previous part of  the current series.

Now, if one invested Rs. 1,00,000/- and there was an opportunity to generate a profit or loss scenario as below, which one would you chose:
o Option A - Max profit of Rs. 10,000/- and max loss of Rs. 10,000/-
o Option B - Max profit of Rs. 20,000/- and max loss of Rs. 10,000/-
o Option C - Max profit of Rs. 50,000/- and max loss of Rs. 50,000/-
o Option D - Max profit of Rs. 1,00,000/- and max loss of Rs. 1,00,000/-
o Option E - Max profit of Rs. 2,00,000/- and max loss of Rs. 1,00,000/-

How many of you would change your choices compared to the previous illustration?

The question to all who changed their choices – the percentage gain or percentage loss was the same in both the illustrations, then why have different choices?

The reason for the change in choice is called ‘behavioral accounting’. For most of us, Rs. 100/- is an amount we are fine to run a risk of 100% loss. If one can get over this problem of mental accounting and based on your risk profile, you CAN INVEST in options linked to the stock market.

Risks and the Stock Markets - Part 4 of 7

Over the last 3 parts, I have touched upon the following:
• Perception of ‘Risk’ as the measure of ‘gain’
• Money can never be completely safe – its ‘purchasing power’ diminishes
• Zero ‘Risk’ is Zero ‘Gain’
• Governments don’t have the mandate to keep your money ‘safe’ and keep it ‘growing’
• Saving is not investing

Let’s now identify the degree of risk aversion one is comfortable with:
If one had Rs. 100/- and there was an opportunity to generate a profit or loss scenario as below, which one would you chose:
o Option A - Max profit of Rs. 10/- and max loss of Rs. 10/-
o Option B - Max profit of Rs. 20/- and max loss of Rs. 10/-
o Option C - Max profit of Rs. 50/- and max loss of Rs. 50/-
o Option D - Max profit of Rs. 100/- and max loss of Rs. 100/-
o Option E - Max profit of Rs. 200/- and max loss of Rs. 100/-

In the above illustration, inflation is considered as money value destroyer. Hence, profit and loss scenario can occur at the same time.