Adjusting nominal returns to reflect inflation should be an automatic process for every investor. Sadly, it is not. Everybody knows equity returns are volatile. So is inflation and its fluctuations over the long term also need to be tracked.
The returns can look stunningly different once adjusted for inflation. The website http://capitalmind.in/ has just done an analysis that reveals how frustrating investing can be and the sheer length of time it may take to generate positive returns.
Deepak Shenoy of Capital Mind assumed Rs 10,000 was invested in the Nifty in 2000. He further assumed all dividends received would be reinvested in the Nifty itself. Today, such a position would be worth Rs 62,428 in nominal terms. So, the nominal value has grown at a compounded annual growth rate (CAGR) of almost 13 per cent. Shenoy adjusted the returns, using the concept of constant purchasing power. This would mean adjusting the value of the Nifty holding using a price index as a benchmark. In this method of calculation, the Nifty would keep pace with inflation only if the value stays constant. Ideally, the Nifty should beat Rs 10,000 by a substantial margin to justify carrying equity risk over the long term.
For example, say the chosen price index was 100 in 2000 when the investment was made. A year later, let's say the price index was at 105. Then the purchasing power of Rs 10,000 cash would be Rs 10,000x100/105, or Rs 9,523, in 2001. Thus, the purchasing power would have dropped, given inflation. In a deflationary scenario when the price index fell, the purchasing power would increase.
Obviously, the exact calculations, including the choice of price index (or price indices), methods of averaging if any, the number of data points, etc , would all be important details. However, assuming the methodology is sound and logical, such a calculation should give us a good idea of how the asset holds up in the face of inflation.
In one sense, Shenoy's calculations could be over-optimistic. In practical terms, an index investor would have to buy an index fund or ETF, and would not receive the benefit of reinvested dividends. That in itself would slice returns down by about 1.5 per cent to two per cent per annum compounded and the difference is huge over the long term.
Shenoy's calculations show the purchasing power of Rs 10,000 invested in the Nifty in 2000 would now be Rs 22.115. It hit a peak of 26,640 in March 2015, an earlier peak of Rs 24,176 in 2010 and an all-time high of Rs 29,498 in 2007.
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