Financial term of the week- Inflation
Let us see how the cost of some of the goods has changed over the last decades.
Petrol prices: goodreturns.in (price as on 30th June for Mumbai)
As you can see, the cost of the same commodity has increased manifold from 1990 to 2020. In other words, the value of money has decreased. This increase in the cost of the goods and services, resulting in a decline in purchasing power, is called inflation. It is not the increase in the cost of any one item or service but is the overall increase in the purchasing price.
Inflation can happen for a variety of reasons, such as an increase in demand, a decrease in supply, an increase in the cost of manufacturing of goods, increase in disposable income, and many more such reasons.
What does it mean for you?
Since inflation is basically an increase in the cost, it implies that what you can buy today, you may not be able to buy a few years down the line, for the same cost. This applies to something as small as a packet of biscuit to bigger things like your house. Therefore, to be able to maintain the same lifestyle, it becomes imperative that your income and capital gains grow at a pace faster than the inflation rate or at least at par with it.
As implied above, if your income cannot keep pace with the inflation, you will have to make changes in your lifestyle to keep the spending constant.
How do you plan your investments with inflation in mind?
Let’s break it down. You invest your money for it to grow and possibly get you capital gains which in turn may help you achieve the goal in time. For example, if you are saving for your child’s higher education, you’d want to accumulate a certain amount by the time he/she is 17, so that the investment can pay for his/her admission. Keep in mind is that if the course in question costs you, say, Rs 10 Lakh today, it may not cost you the same at the time of admission, because of inflation. Hence, you must invest for the inflated cost and not the present cost.
Assuming an inflation rate of 6% per year and the age of your child to be 3 years, you have 14 years till college. Now, a course that costs Rs 10 Lakh today, at the said inflation rate will cost Rs 22.6 Lakh. Let us assume that you choose the systematic investment plan (SIP) mode of investment in a mutual fund wherein you invest a predefined amount at regular intervals, with a hypothetical CAGR of 10%. Now, to achieve Rs 10 Lakh you would have had to save ~Rs 2800 per month for 14 years; but because of the inflation, you’d have to invest ~Rs 6200 per month to achieve the inflation-adjusted target.
Thus, it is essential to plan your investments in such a way that you the inflation-adjusted returns can help you achieve your goals accurately. Here, is where portfolio diversification and asset allocation come into play, so that your risks are spread out, and so are your returns.
(Past performance may or may not sustain in the future and the same may not necessarily provide the basis for comparison with other investment)