Handling inflation for personal finance requires a “Personal Finance Inflation Index”

While financial planners have their own opinion on inflation, institutions involved in conducting financial planning courses in India have never thought of an inflation index, which shows that there is very limited innovation in financial planning in India

All financial planning advice has one thing in common and that is how to handle inflation while creating portfolio of assets. It starts with the idea that investments made by an individual must beat inflation, else effectiveness of financial planning is lost and there is no real wealth creation. The idea sounds great. But is it possible to implement it so easily? Is there a common and convenient answer to this question? Talk to financial planners on this issue and they will answer this question more with gut feeling rather than a scientific analysis.

Some of the most common answers given on the issue are, “your investment must beat CPI or food inflation”, “your investments should generate at least 8% return as we have considered 8% inflation” (Interestingly, source of 8% is not known). Some other planners say that for education, healthcare and energy-related expenses a higher rate of inflation needs to be considered. But the question still remains unanswered—which rate of inflation needs to be considered for personal financial planning.

For reading what Morgan Stanley has to say about India’s CPI, click here.

It is extremely important to handle inflation scientifically and not based on some arbitrary number as inflation has a potential to derail the entire financial planning process. After all, inflation does not impact everybody equally. It depends on the level of income and consumption pattern of an individual. For a person with lower level of income, food inflation matters more than anything else, while for a person drawing a handsome income, food inflation will not be the same cause of worry.  This will make an impact on the inflation planning approach of both the individuals. Similarly educational and rental expenses have increased phenomenally during last five years and unfortunately no inflation index captures this. So how we handle this strange scenario? The solution of the problem probably is in creation an inflation index which will be focused on personal finance.

What is most surprising is that while financial planners continue to have their own opinion on inflation, institutions which are busy in spreading certification courses (and probably minting money) on personal finance in India have never thought of working such ideas which shows that there is very limited innovation in financial planning in India. If the National Stock Exchange (NSE) can create a Volatility Index (VIX) for measuring volatility, why not have a separate index for inflation for personal finance.

How the personal finance index should look like?  The personal finance index should be made up of expenses that comprise day-to-day expenses of individuals. Like any index there should be weightage assigned to important expenses such as rental, food, healthcare, education, etc. The index can be one common gauge but can be used differently by every individual and will be based on expenses of an individual. Additionally, this expense need not be calculated weekly or monthly. Once in a quarter computations should be good enough. Since portfolio churning is not done frequently, frequency of index computation once in a quarter makes sense. The idea here is capture those expenses which impacts the expense pattern of individuals. Some of the expenses such as those on education, healthcare and recreation are not captured by traditional inflation indices like WPI and CPI.  This index will remove all such anomalies.

Who will create this indexIdeally the index should be created by institutions such as “Financial Planning Standard Board” but it seems such institutions have limited capabilities in this direction. The next entity could be the financial planner who helps you build your financial plan. Logically the financial planner should record price trends in the economy. This means that at the start of financial planning the index value should be created and be used periodically to check whether investments have been able to beat inflation or not. However, an individual can also create an index by tracking his own expenses and changes in it. This is not a cumbersome exercise and can be done by recording transactions and prices associated with transactions in a simple software like MS Excel. However, an individual’s index can at best be used by only limited individuals who show similar pattern in expenses.

It is unfair to leave financial planning exposed to vagaries of inflation. Beating inflation needs a deeper analysis of inflation and its impact on investments. A hit and trail approach cannot be the benchmark of financial planning.

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