Understanding how inflation can affect your savings and investments is the first step towards protecting your investments from its adverse effects.
Rakesh had invested ₹ 1 lakh in 2016 in fixed deposit of 5 years duration at rate of interest of 7%. He prefers to invest in fixed deposits because they offer surety of capital and clarity of return over the investment period. Now, in 2021, his FD has matured and his initial investment has grown to ₹ 1.45 lakh. Rakesh is happy that his saving have paid off and he has earned ₹ 45 thousand on his initial investment. He is, however, unaware that along with the government, through tax on interest, there is someone else having a bite out of his savings. It is the invisible demon ‘Inflation’.
What is inflation?
Inflation is rate of loss of purchasing power of money i.e. with inflation you would have to pay a higher amount for the same product. If you remember how big the size of ₹ 10 Dairy Milk chocolate was 10 years back compared to what you get today. Inflation has been eating into your chocolate. Further, inflation of 4% would mean that the product that costs ₹ 100 today would cost ₹ 104 next year.
What is the impact of inflation of Investments?
Because inflation operates silently in the background, many people fail to recognize its eroding impact on their investments until it’s too late. Inflation not only reduces the purchasing power but also increases the requirement of capital for future purposes. The impact that inflation will have on your investments will depend on the type of your investments.
Inflation has a major impact on investments like fixed deposits, bonds, etc. which earn a fixed rate of return. Consider our example of Rakesh, his FD earned him a return of 7% per year but the rate of return after taking into account inflation would be much lower. Assuming the inflation to be 4% throughout the period from 2016 – 2021, the real rate of return has been only 3% (7% - 4%). Therefore, the inflation adjusted return is only ₹ 16 thousand. After considering the impact of tax, the return on investment decreases further.
In case of equity investment, the impact of inflation can be mixed. Inflation is generally high during periods of growth. Companies enjoy higher sales which could result in higher share prices. However they have to pay higher raw material costs, wages, transportation costs, etc. which have negative impact on their share prices. Whether inflation will hurt share prices would depend on the performance of the company.
Inflation has a positive impact on price of precious metals like gold because as the value of money reduces, it costs more to buy the same amount of gold.
Can we avoid inflation?
Inflation is a reality which cannot be avoided, but by being aware about inflation and acknowledging its presence we can invest smartly to extract higher returns from our investments. Instead of investing only in fixed return instruments like debt funds or FDs we should consider instruments which have a mix of both debt and equity. Debt portion would provide stability and security while equity portion would provide capital appreciation.
One way to analyze the performance of your investment would be use the real rate of return earned by the investment.
Real rate of return = (1 + return) / (1 + rate of inflation) - 1
Be smart and invest wisely.
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