Inflation & Investing

We know you are very smart with your life. You already have a retirement goal. You are investing every month diligently. By remaining disciplined you will surely create the targeted amount to support your retirement life. But what if that amount suddenly seems inadequate to support your lifestyle. What happened, did you miss something, what you could have done better? What you have planned is according to your present time and what you will be spending after retirement is in the future. As you are growing your money using compounding there was a termite named Inflation that was eating the value of your money quietly.

Inflation reduces the value buying capacity of our money. So Inflation can be understood as negative interest rate.

Reason of Rise in Prices

The price of something is determined by supply and demand. The demand for commodities increases if people have more money. This may happen because of lower tax or through the availability of affordable loans. Even though people have more money, they cannot purchase more if the manufacturing of goods and service offerings do not increase at the same rate. So, people start offering more money for the same item and consequently prices increase.

Inflation erodes the purchasing power of money because as prices rise, the same amount of money can buy fewer goods and services. You get less and less for your money as everything becomes more expensive. The worth of every single Rupee decreases slightly. This indicates a decline in purchasing power. Inflation hurts low income poor people more severely. 

Optimal Inflation Rate

Inflation is not always detrimental. A high inflation rate, above 5%, is risky because it causes money to quickly lose its value. Less can be bought, and people become less confident in their currency. Planning long-term investments is challenging for businesses when inflation is high because it is challenging to secure loans and to accurately predict future profit margins.

But not everyone loses because of inflation. As a result, debtors gain since the value of their debt decreases. Additionally, physical investments like real estate gain in relative worth. The economy can even be stimulated by modest inflation rates: When people believe that their money is worth less than it once was, they prefer to invest it or use it for consumption.

Real Inflation Rate

The Reserve Bank of India tries to keep inflation at 6%. Annual inflation reported in India is generally somewhere around this number. But, we as consumers may be facing price rises that are not reflected in the news reports.

We tend to be more sensitive to price increases for everyday essentials, like groceries, because we buy them frequently. This can make inflation feel higher than it actually is when compared to less frequent purchases like cars or appliances. However, it’s important to remember that inflation applies to all goods and services over time, including those we buy less often.

Effect of Inflation

One commonly used rule of thumb to measure the effect of inflation is the “Rule of 72.” This rule provides a quick and easy way to estimate the time it takes for prices to double based on a given inflation rate. Here’s how it works:

Divide 72 by the annual inflation rate (expressed as a percentage) to approximate the number of years it will take for prices to double.

For example:

– If the inflation rate is 6% per year, divide 72 by 6 to get 12. This means that prices are expected to double approximately every 12 years with a 6% inflation rate.

– If the inflation rate is 10% per year, divide 72 by 10 to get 7.2 (rounded to 7). This means that prices are expected to double approximately every 7 years with a 10% inflation rate.

– If we consider general inflation rate at 7% and an insurance plan is going to provide a lumpsum maturity benefit of 28 lakhs in 20 years. Because of inflation, the 28 lakh maturity benefit is about ¼ th or 7 lakh in terms of today’s money.

– If a college education costs 15 lakh today and education related inflation is 10% then in next 20 years the same degree will cost 8 times i.e., 1.2 crores.

Historical Inflation

Inflation has been reducing the purchasing power of money from foreever.  If we look at the effect of inflation since 1960 we find that rates of inflation as below: 

Cumulative Inflation: 471.81%

Average Annual Inflation: 7.37%

The Indian Rupee has lost 98.88% of its domestic purchasing power between 1960 and now. Today, we need 89.09 to buy the things that 1 rupee could have bought in 1960.  

Historical evidence suggests that the high inflation in developing countries shifts towards lower and more stable inflation as they mature economically. This also results in lower market interest rates in the developed countries. For example, bank interest rates and share market index returns in the USA or Japan are much lower than those in India.

Effect on Debt

Inflation can affect the real cost of debt by reducing its value over time. Individuals who hold fixed-rate debt, such as housing loans or student loans, may benefit from inflation as the real value of their debt decreases. However, variable(floating)-rate debt may become more expensive to service if interest rates rise in response to inflation.

Psychological Effects

Inflation can have psychological effects on individuals’ financial attitudes and behaviors. High or volatile inflation rates may lead to feelings of uncertainty, anxiety, and loss of control over finances. This can influence decision-making processes related to saving, spending, investing, and retirement planning, potentially leading to suboptimal outcomes.

Beating Inflation

What can we do to maintain or increase the buying power of money we have? 

Invest Wisely

Inflation only hits the money you use to consume. You can save and invest from your income to generate higher returns than inflation. Invest in assets that have the potential to outpace inflation over the long term, such as Mutual Funds, stocks, real estate, commodities, and inflation-protected securities like Inflation linked Govt bonds etc. Diversify your investment portfolio to mitigate risk and capitalise on growth opportunities. Investment should be done in instruments which give a higher rate of return than the average inflation rate i.e. 7%. Investing in assets that have the potential for growth that exceeds the rate of inflation increases the purchasing power of investors.

Investments and Inflation

While saving our income and investing it for the future we need to be aware about the real (post inflation) returns generated by our investments. Most of the “safe” investing options offer returns that are lower than or marginally higher than the rate of inflation. Most Bank FDs generate negative returns after accounting Inflation. Negative rate of returns means that investors are losing money by investing in such instruments. Because in the future, money is of lesser value than invested. Tax on interest earned from FDs additionally reduces the overall returns.

Reinvest Returns

Reinvesting dividends, interest, and capital gains allows you to compound your returns over time, accelerating the growth of your investment portfolio. Compounding is a powerful wealth-building tool that can significantly enhance your purchasing power over the long term.

Stay Invested for the Long Term

Adopting a long-term investment approach and resisting the urge to react to short-term market fluctuations can help you capture the full potential of compounding and ride out market volatility. Time in the market, rather than timing the market, is often the key to achieving meaningful growth in purchasing power. Historically, staying invested in the stock market through various economic cycles has yielded positive returns that outpace inflation over time.

Diversify Income Sources

Diversifying income sources is a smart financial strategy that involves generating revenue from multiple streams rather than relying solely on a single source of income. By diversifying your income, you can spread risk, increase stability, and enhance your overall financial resilience.

By implementing these strategies and staying disciplined in your investment approach, you can effectively preserve and grow your purchasing power, enabling you to achieve your financial goals and maintain your standard of living despite the challenges posed by inflation.