What is inflation and how does it impact your investments?
It is the rate at which goods and services become costly every year in a country. For example, if I buy dal for 100/Kg today and next year if it increases to 110/Kg it means dal has an inflation of 10%.
So whenever there is inflation the buying power will be less. For example, if I have 100 Rs and today I am able to buy 1 Kg dal, after a year for the same 100 I’ll be able to buy only 900 grams of dal.
Now let us assume that inflation is 10% on an average every year. The below table depicts the dal price for next 5 years and how much dal can be bought for 100 every year.
So during year 5, a person will be able to buy only 0.68Kgs of dal for the same money. However, he will require 1 Kg of dal. So he needs to spend more money.
What causes inflation?
- Increase in demand: If the demand for a commodity/service increases more than its supply then naturally the prices will increase causing inflation. For example since there is a dearth of good medical facilities in India, the inflation in medical sector is way higher than normal.
- Increase in production cost: When the production becomes costly the prices also increase. Production costs may increase due to increase in wages, increase in raw material cost etc.
How is inflation measured?
In India, there are two indexes through which it is measured. These are:
- Wholesale Price Index (WPI): This index tracks the changes in the wholesale prices. This means it does not include the changes of price in the retail market. Also, it does not include services such as housing, education etc.
- Consumer Price Index (CPI): This index tracks the price changes in a number of goods and services which are representative of consumer expenditure at retail level.
For general population CPI is a better measure to track the inflation. However, since it has a fixed weightage of each good and service included in the index, the real inflation varies from person to person. For example, in urban areas people spend more on lifestyle than the essential goods and services; hence the impact of lifestyle inflation is more on them.
In the past medical, education, entertainment inflation etc. have been higher than normal and hence resultant inflation is higher than the CPI.
Impact of inflation on investments
Due to inflation 100 Rs. that you have today will be lose their value and be less valuable by next year. Hence, you need to invest your money so that you can get returns on your investment and preserve or increase the value of your investment.
However, if your investment will stay in savings bank account or FDs, then you will possibly get lower returns than inflation and your real returns will be negative.
Therefore, investing in mutual funds, that too in equity funds for long term becomes necessary. Equity is an asset class which gives inflation beating returns over long term.
A Case Study
Mr. A had Rs. 2,000 in Savings bank account, out of which he invested Rs. 1,000 in a large cap equity mutual fund for 5 years. Let us consider below data:
Average Inflation: 6%
Average Savings Bank Account Returns: 4%
Average Large Cap Equity Returns: 14%
After 5 years, the inflation adjusted values are:
Savings Bank Account:
Returns before inflation: Rs. 1,338.23
Inflation Adjusted Returns: Rs. 909.15
Large Cap Equity Fund:
Returns before inflation: Rs. 1,925.41
Inflation Adjusted Returns: Rs. 1,438.78
You can see that while the value of money in savings bank account decreased due to inflation, equity mutual fund’s high returns caused an increase in the investment value even in real return terms.
The above two investments are of different asset class and differ in the risks involved as equities are highly volatile. However, the inflation risk is much higher if all your investment remains in savings account or FDs and the impact will be enormous in your portfolio over long term.
Hence, to generate inflation beating returns over long term, it is a prudent choice to invest in equity mutual funds.
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