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Inflation affects your earnings, your investments, what you can purchase and your lifestyle. It may seem like a technical concept best left to economists to discuss, but here’s why you need to know more about it.

In March 2010 various agencies are expected to assess inflation for the fiscal year of 2009-2010 at anywhere from around 6.5% (RBI estimate as of October ‘09 policy review) to 8% (as per Citi economist Rohini Malkani, noted Dec 14, 2009 in the Economic Times).

That means, since the previous tax year, on average goods and services in India will cost from 6.5% to 8% more than the previous year.

With luck, you may have had a salary increase of that amount to keep up with your lifestyle expenses. With the economic downturn, you may not have had the increase.

What about your investments? If you held a diversified portfolio with debt and equity and earned around 15%, you are doing well. You earned money in real terms. Anything more than that is icing on the cake (provided the investment continues to do well, that is, or you sell it). If you held all your money in FDs yielding 6% to 7% or in a cash account at the bank earning 3% to 4%, then you actually lost money this year. You will be able to purchase less for the same price than you could last year.

This concept is hard to accept: you want your money to be safe and stable but in going the totally safe route, you may be losing money long term. Many Debt products can be safe options and return a bit more than inflation. A Provident fund investment (obligatory for many in large companies) earns currently around 8%.

We are not discounting debt and other safe options for your money—it is an important part of every portfolio, giving stability through assured returns, safety through the fact that it is a non-correlated asset (meaning debt won’t decrease in value when shares do, usually it will increase in value) and an assurance that it will be there no matter what. If all the companies that we invest in through mutual funds and/or directly, went bankrupt (obviously not likely), in theory, the Provident Fund and other debt options would still be there to see you through.

Really the best option, however is to be sure you have enough diversity in your portfolio to allow for growth, best captured through equity. Equity tends to grow faster than debt and usually outpaces inflation.

Inflation is more important for emerging markets like India than developed markets. The currency, economy, prices and general economic system are more volatile and growing faster and will generally produce sharp swings in inflation that must be closely monitored. If you watch carefully, invest well and are well advised, you can do well. In a highly inflationary environment, investments will often also earn higher returns to reward investors.

Inflation is often matched by fast growth rates which produce good earnings for companies that people and mutual funds invest in. But it musn’t get out of control. This is why the government closely monitors inflation to make sure it won’t get too high. If it does, watch for fiscal and monetary policies like taxing inflows of foreign dollars, raising interest rates and removing any stimulus measures put in place during the economic slowdown. One impact of the very slow to negative growth we are currently seeing in many of the Western countries is near zero inflation. It corresponds to growth.

This is why inflation is not static. Inflation for assessment year 2007-2008 was 4.5%. It changes all the time and we are not able to predict it with great accuracy. This is why it helps to keep an eye on it.

Another factor to be aware of is how uneven inflation can be. Education costs in both the USA and in India have far outpaced average inflation for many years. At InvestmentYogi in our financial plans, we currently use an inflation figure of 6% (this represents a historical average with future predicted inflation factored in) and an education inflation figure of 10%. This is important when planning your child’s higher education, whether in India or abroad. Food prices worldwide also fall in the higher inflation rates (for November alone increase was 19% as per Economic Times of Dec 14), and are expected to for years to come, while other consumer goods may not have changed prices or may have gone down.

Retirement is a key area to watch out for. You must save large amounts and save early in order for earnings and compounded growth to increase sufficiently to support you in your old age. Think about 7% (if inflation stays there!) per year for the next 40 years. Just make sure that money is diversified in your investments! And for current retirees, they need to have access to “Safe” money but woe to those who don’t hold some equity and are looking at the next 20 years in retirement. That is a long time to make your money last in a world of rising prices. The era of company-offered pensions is declining and one must look out for oneself. Even those with a pension will fast find its value eroding if the pension amount is fixed and the economy is not.

Aside from diversification, there are some other tools to look for. Pension funds you can buy generally track inflation, as do some other investments. This is a sort of guarantee that inflation will not outpace your funds.

Whatever your strategy, be aware of the inflation rate and make sure you are keeping up with it, if not surpassing it, in your investments and other earnings. And be sure to talk to your elders about these concepts, which may be foreign to them. Older people tend to prefer “safe” investments but make sure they are not being so safe that they lose money! Once their earning power is gone, they need the money more than anyone else.

All signs tell us that inflation is around the corner. Today March 21, 2009, nobody knows exactly how steep price increases are going to be. Should we expect a rise between 5% and 15% per year during the next thirty six months? To which extent should we fear a much higher inflation?

Whatever the answer to this question, I am already adopting for my own investment portfolio a defensive strategy against inflation. Since I am too much of a dividend lover and I know little about precious metals, I am not going to purchase gold.

In my view, there are two alternatives that should lead to results that are roughly similar to purchasing gold:

* Investing in oil companies, since sooner or later, inflation will propel oil prices to a higher plateau.

* Buying shares of companies that operate in countries with short-term prospects of economic growth.

At this moment, I am considering the following five companies for possible purchases for my own investment portfolio:

1.- MARATHON OIL (NYSE:MRO). The current low price of oil has driven down these shares more than 40% during the last year. Their price/earning ratio today is about 5 and they are yielding around 3.5%. The profits of this company should rise if oil prices go back to the level of a few months ago.

2.- CHEVRON (NYSE: CVX). The low price of oil these days has pushed these shares more than 20% downwards during the last year. The current price/earning ratio is about 5.5 and the yield around 3.8%. This is another company that should benefit from a rebound of oil prices.

3.- CHINA MOBILE (NYSE: CHL). Their number of cell phone subscribers continues to increase and their profits should go up or, at least, remain stable. If the Chinese currency gains value, this will result in extra profits for international investors holding these shares. The current yield lies around 3.5% and the price/earnings ratio is about 10.

4.- TELKOM INDONESIA (NYSE:TLK). With a current yield about 8% and a price/earning ratio of 11, these shares allow an easy way to invest in the Indonesian economy. The company provides fixed line and cellular communications and serves more than 63 million customers.

5.- AMERICA MOVIL (NYSE:AMX). The price/earnings ratio is about 11 and the yield is around 1.5%. This company operates cellular phone networks in Mexico, Argentina, Chile, and other South American countries. They provide services to around 150 million customers.

These five large companies should offer no great operational surprises. I am risk-shy and this is the kind of investments I favour in my own portfolio. Can anyone guarantee a rise in the shares of oil companies and international telephone providers? No, nobody can offer such guarantee.

For my own investments, I try to rely on reasonable assumptions and these five companies seem reasonably well positioned to maintain their value in case of high inflation.

See John Vespasian’s blog

http://johnvespasian.blogspot.com/

Inflation is something that every investor should know about. The wise investor understands how inflation erodes their purchasing power and he or she takes steps to mitigate the damage.

Inflation is when the price of goods and services rises at a rapid rate. This destroys your purchasing power. Ever heard that a dime doesn’t go as far as it used to? That is due to inflation.

In theory, stocks are able to take handle the effects of inflation. This is because revenue and earnings usually increase at the same pace. However, for this to happen prices have to rise. Many companies face global competitors that offer different inflationary pressures, which prohibits the increase in prices at a rate to keep up with domestic inflation. In other words, not every company can afford to increase the prices for their goods and services.

When the economy is looking at inflation, the Fed usually increases interest rates to slow growth. This cools off the economy, but isn’t the best news for companies. Higher interest rates entice consumers to reduce spending, which takes money away from many sectors.

Stocks are often toted as good protection against inflation. In broadly diversified portfolios, stocks do help mitigate against inflation. If you invest everything you have in stocks, you are probably fairly protected against inflation. However, most diversified portfolios have cash and fixed income securities. These are vulnerable to inflation.

Let’s look at some numbers. Whenever you are thinking about your percentage of return, think about inflation as well. For example, if your stock investments give you an average annual return of 10% and the annual average inflation is 3%, the actual return you have from your money is really 7%. Think of it this way — what you are making now will actually buy less in the future — so you may need a little more than you anticipate. That is why you should factor in inflation.

But if you have a 6% bond and inflation is 8%, you have a negative return on your money.

I’m not saying don’t invest — but if you are nearing or already in retirement, inflation is something you should take seriously. While many people assume that all of your portfolio should be switched to fixed income securities, that might not be the right way to mitigate inflationary pressures on your portfolio. Even in a low inflation environment, it is often wise to keep a portion of your portfolio in stocks to counteract the loss of purchasing power.

Remember, there are stocks out there that are pretty good bets. Large, existing companies that have excellent and solid histories are good options. Think your blue chips here.

Don’t go out and change your portfolio right away. If you don’t see a problem, keep doing what you are already doing. But keep an eye on your portfolio. When planning your investment goals, keep inflation in mind. Keep an eye on your fixed-income securities. Plan ahead.