Inflation factor

The rising prices are not just affecting your current expenses, they are also eroding your investments

Are you sure you know what your investment is worth, say five years or 10 years from now? Most people don't. They value their investments at the nominal rate of returns. However, the nominal rate of return only tells you how fast your investment is growing, not how much it is really worth. For that, you need to calculate the real rate of return—the rate of return after taking inflation into account. This is because inflation not only affects the purchasing power of your money, it also reduces the effective rate of return on your investments.

How is your money growing?

Calculation of real rate of return gives you an idea of the growth in your purchasing power or growth after adjusting the impact of inflation. Let's understand this with the help of an example:

Say you have invested Rs 10,000 for one year at the rate of eight per cent per annum. At the end of one year, you will get Rs 10800—your returns are Rs 800 on Rs 10,000 invested.

What you need to check is whether this Rs 800 gives you the same purchasing power it gave you one year back. To calculate that, we use a simple formula, which is:

Real Rate of Return = {[[1+ Rate of Return]/ [1+ Inflation]] - 1}*100

Continuing the above example, let's assume the rate of inflation is four per cent. Then your real rate of return is:

[{[1+8 per cent]/ [1 + 4 per cent]}-1]*100 = 3.85 per cent.

In the above example, though you have earned eight per cent, the actual purchasing power of your investment is worth Rs 10385 [Rs 10,000 + 3.85 per cent on Rs 10,000, which is Rs 385]. The difference between the nominal rate of return and the real rate is Rs 415! And we haven't even considered taxes yet. When you consider those, you'll realise that what you get from your investments is hardly anything. For instance, you fall under the 30 per cent tax bracket.

This means out of the eight per cent, you will have to pay 2.4 per cent towards taxes [not taking into account education and secondary education taxes]. So from Rs 800 you get Rs 560 in hand after deducting taxes. From this when you calculate four per cent inflation your real rate of return comes to 1.54 per cent—Rs 154. Hence, your returns are Rs 10154.

The rate of inflation we have considered here is very low, it's hypothetical. On an average, rate of inflation is taken as at least eight per cent.

Why consider inflation

You should factor in inflation because:

For long-term goals

You have a goal of saving Rs 5 lakh for your daughter's wedding, which is 20 years away. But the amount you require then would be much more than Rs 5 lakh. Why? Because of inflation!

Considering inflation will tell you the right amount for which you need to start saving. Take the rate of inflation as four per cent, then the amount you need to save for is Rs 10.95 lakh [rounded off]. This is double the amount you had first intended to save up.

For insurances

You might be happy that you will be getting Rs 20 lakh from your traditional insurance policy at the end of 30 years. For this, you will be shelling out at least Rs 1 lakh as insurance premium. But, what is the value of Rs 20 lakh after 30 years? Do you think it will suffice your family's needs? Let us find out what the value of Rs 20 lakh in present terms will be.

Here is where present value of money comes into picture. Present value [PV] of money tells you what is the real worth of your investment plus returns [which you are going to get after "x" number of years] in today's time.

With this you can determine the extent of fall in the purchasing power of money. It helps you determine if it would be enough to sustain you financially.

Present Value = Future Value X 1 /Rate of Inflation ^ Number of years

In the above example, you will get Rs 20 lakh after 30 years. Hence,

Future Value: Rs 20 lakh

Number of years: 30 years

Rate of inflation: 4 per cent

PV = Rs 2,000,000 X [1/4] ^30 = Rs 6.16 lakh [rounded off]

You think this will suffice? Think again and act accordingly.

For retirement

Here too PV plays a very big role as you need to calculate the amount you require to sustain you for at least 20 – 30 years post retirement. So invest taking into account your real rate of return.

Smart investment instruments

Investing wisely is the only way to beat inflation. [The actual impact of taxes and inflation, however, depends on the type of investments].

Equity

Invest in equities or an equity-oriented mutual fund, and you can be sure that in the long run, they will beat inflation. This is because a company's earnings increase at the same pace as inflation. But, venture into this form of investment only if you have the risk-taking capability and long-term investments of at least more than five years.

Gold

Investment in gold has always been considered an inflation beater. Experts recommend five per cent of your portfolio to be invested in gold as it is the most liquid asset in the world. Although the returns have surpassed inflation in recent years, it is vital to be aware that as and when global economy picks up, gold may not beat inflation. On the whole, beating inflation or not, certain amount of investment in gold is good.

Real estate

Going by the 'boom period' of property markets in the past few years, holding real estate for a long tenure definitely beats inflation. In fact, real estate gives the highest returns among all investments. The drawbacks are huge amounts of initial investments and liquidity. But well-researched investors can reap superb benefits.

Debt

Fixed income investments [like fixed deposits] are the hardest hit. The yield earned is not more than 7 – 8 per cent. Individuals in high income tax bracket have to pay 30 per cent tax so the net returns they get on these instruments is hardly anything and definitely does not beat inflation. Debt instruments, too, are the hardest hit with the rising inflation.

We are aware of rising prices of daily commodities but not of how they also erode your investments. The best way to beat inflation is to use the power of compounding by investing as early in life as possible.

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Sheetal Jhaveri
Sheetal Jhaveri holds MBA[Finance] and CFP degrees and is also certified by AMFI and IRDA. She runs her own financial consultancy in Mumbai and writes on finance for several leading publications. Besides her profession, she loves to travel, read and paint.

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