Deflation – Does it affect financial planning?

After years of rising prices and declining purchasing power, a new worry has sneaked into the minds of investors – The Deflation

Deflation – It means decline in price levels. It is when asset and consumer prices continue to fall. It occurs when inflation rate falls to below zero percent.

This may seem like a great thing to consumers. But it can be very dangerous situation. It also means there is no demand for goods. People start deferring their buying in anticipation of further price drops. As a result people tend to hoard cash instead of investing. If deflation stays for longer period, it means that a recession is already underway. As a result job loss, declining wages, decline in the value of your assets and your investment portfolio.

So, does it affect financial planning?
It is common that investors, who generally predict returns as high as 15% to 20% during good times become extremely pessimistic in their expectations during recession, and may indeed, significantly cut down on their investment levels.
In such a situation financial planning is of great help. Financial plans, when done in a proper manner during recession, can help investors achieve their targets. Planning should be neither too optimistic (as during bullish phase), nor too bleak (as during recession). Financial planning, especially during a deflationary phase, encompass of the following strategies:
a) Review of Investment Goal: Investors always have certain goals in their mind as they frame their financial plans. These goals also generally accompanied by distinct time-frames within which to achieve them. However, the ability to invest is adversely affected during a recessionary phase. In such a scenario, the initial investment plans might need to be revised and/or toned down according to the situation. When an economy experiences a decline, individual incomes are badly affected and hence, reducing their ability to invest. This results in individual debts being paid off less quickly than what might have been imagined initially. The time-frame required to achieve one’s investment goals may need to be extended during recession.
b) Reassessing of Risk Tolerance Levels: Based on how ready an investor is to take risks in order to gain higher returns can be classified as ‘risk-taker’, ‘risk-neutral’ or ‘risk-averse’. During recession, individuals need to accurately asses their risk-tolerance levels, and then choose the investment plans that would suit investor’s preferences.
c) Restructuring of an Individual Portfolio: After a review of investment goals, a restructuring of portfolios that are currently held is also important. It is said to invest in those companies whose products or services are not much affected by fall in demand. So, companies operating in health care, telecommunication and utilities like electricity distribution could be good stake to invest. Services of these companies will remain in demand even if the economy slows down. Investors also need to identify those companies where decline in prices lead to increase in demand for their products, prompting them to produce more value-added products with greater economies of scale. In this category, companies operating in sectors like snacks and beverages, health care, utilities and telecommunications can be included. Sector diversification is an effective strategy, since owning a mix of small-cap, mid-cap and large-cap stocks effectively lower one’s risk, while maintaining a high rate of return attached to a portfolio.
d) Review of Insurance and Estate Plans: During recessionary periods, portfolio income might go down. Consequently, one needs to expand their insurance plans. A thorough review of real estate plans is also necessary.
Hence, financial plans are of great importance during recession.

In Indian Context – Do we really worry about deflation? Does it have any impact on financial planning in India?
In India we don’t need to worry too much about deflation. As we have a very large number of consumer base (being a population of more than 100 crore) so there is always a demand and supply mismatch. Also, India still is a developing nation with very high growth potential in various sectors. In India we follow WPI (Wholesale Price Index) which is not correct for calculations as many items in the WPI is not used by consumers, whereas we should follow CPI (Consumer Price Index) which is hovering around 7.5 % to 8%. Unlike other developed nation we don’t have proper index which can give us correct inflation figure, which financial planners may follow for constructing a financial plan. In Indian context, we have seen deflation only in electronic goods item. In agricultural sector there is no deflation as demand is more than supply because of large population. Even items we regularly use are in great demand. There we don’t see prices to come down.

Hence, even if the WPI may come down below zero percentage still we have to take inflation for financial planning calculations.