The Role of Inflation in Financial Planning

’20 years ago, we could get a sack of rice for the cost of 1 kg today.’‘The capital for my business in 1975 was Rs. 500.’

Are you familiar with such remarks and exclamations from your parents and grandparents? Living costs are constantly increasing. We call it price rises or inflation. So, inflation is an important factor to consider when saving for future. This article will explore why your investments should beat inflation.

Inflation – definition

In simple terms, inflation means the rise in cost of living over time or the decrease in the value of currency. You can relate to this if you think of what Rs. 10 as pocket money meant to you as opposed to children today. For instance, if the annual inflation rate is 5%, what you buy today for Rs. 1000 will cost Rs. 1050 in next year. But does income increase as per inflation? This is where mid-income people and low-income people struggle to maintain their standard of living. 
 

Inflation can indeed exacerbate the battle between income and expenditure against you. So, when you save for future, you must consider schemes that are known to deliver inflation-beating returns.
 

Causes of Inflation

People always talk about inflation as one big economic menace. There are many reasons for that among which the following three are the most common.

Rising Demand

It is basic economics that when a product or a service is in demand, its cost (including that of the raw materials) will also increase accordingly. Why would someone sell a commodity for a lesser price when there are people ready to pay more?

Insufficient Supply

When there is limited supply and more demand, inflation is the obvious result. For instance, the rising housing prices in metro cities like Bangalore and Mumbai. High cost of organic vegetables and fruits is also due to less supply.

Minting Money

Another aspect that prompts price rises is excessive currency flow. With more printed money influx in the economy, the value of currency goes down.
 

Why consider inflation before investing

Inflation is a cause for concern among investors, especially those with less risk appetite (like pensioners) and live on a fixed income. Increase in price will inadvertently impact interest rates too. The effect of inflation on your investment portfolio is based on its underlying securities. Putting your money only or mostly in equities has historically succeeded in keeping up with the pace of inflation. This is because the company’s income and turnover tend to rise in tandem with inflation. So, the share value also increases accordingly.
 

Inflation is an important parameter an investor should consider when he/she invests in any scheme. Low-risk investments like fixed deposits and PPF give returns from 7% to 9%, while with moderate to high-risk investments like mutual funds generate 14% to 20% returns. Mutual funds like ELSS offer you inflation-beating earning potential. Thus, you will be able to retain or boost your current living standards.
 

How to get inflation-beating returns

Just saving money from your salary now may not be enough to meet your financial goals in 2030 after taking inflation into account. Investors need to make timely and informed decisions to ensure that inflation doesn’t gobble up their savings.

Bonds

There are many bonds you can choose to make inflation-beating returns. One example for this is Treasury Inflation Protected Securities, also called as TIPS. It is a government bond designed to make up for possible inflation. But if inflation is low, this can backfire and result in less returns. 

Commodities

It depends on the type of product. For instance, gold and silver have always managed long been able to cut down losses by inflation. But food commodities could never hedge against price rises.

Mutual funds

Long-term mutual funds like ELSS, gilt funds and dynamic bonds have delivered good returns in recent years. Also, debt funds if held for at least 3 years can generate long-term gains.

Laddering

This is a concept in which you continue to reinvest your money gained from earlier investments once they mature. Say, you receive a corpus of Rs. 2 lakhs from an older FD after maturity. You can invest a lakh each in a one-year and two-year schemes. This way, you keep earning from your investments.

Smart conversion through debentures

We are talking about convertible debentures (complete or partial) that can be changed into shares after certain term. If the interest rates come down, you can convert it to equities to hedge losses.

Calculated risks are not as risky as impulsive risks

This is not merely investing in more bonds or mutual funds. Investing in company deposits can be risky but also rewarding if you opt for rated companies.

Get dividends

Many fund houses now choose to share their profits with investors. If you choose plan that gives the benefits of both debt and equity, you can get dividend annually.
 

In a nutshell, investors must take inflation into account when making investment decisions. If you invest with Cleartax Invest, rest assured that your money goes into top performing funds from India’s premier fund houses. We will only choose well-researched plans that will deliver inflation-beating returns for you. Start investing.