Inflation is the general rise in the prices of goods and services with time. What’s dangerous about inflation is it eats your money. Inflation makes money saved and invested today, less valuable tomorrow. It erodes your purchasing power and interferes with your ability to retire.
Let’s understand this with a simple example. If you got 7% from mutual funds in a year, and the inflation rate was 4%, you earned only 3% in real terms. This is also called the real rate of return. The 7% return you got from mutual funds is called the nominal rate of return.
Find inflation difficult to understand? Well it’s simple. What compound interest gives, inflation takes away. Take a look at this fact. A sum of Rs 10,000 in 1982 is worth just Rs 552 today. Inflation is effectively the reverse of compound interest.
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Let’s say you have invested Rs 2 Lakhs in an FD which offers 7% a year. Prices of goods and services are also rising at 7% a year. The compounding returns just about keep pace with inflation. The amount goes up, but you get no benefit from this.
You have the rule of 72 where you divide 72/x. This shows how long it takes for your money to double.
x = rate of return from the investment. If you are getting 6% interest from the investment, this is 72/6 = 12 years. It takes 12 years for your money to double.
Let’s say the Rs 1 Lakh you invested 12 years ago has become Rs 2 Lakhs. At the same time the things you could have bought for Rs 1 Lakh costs Rs 2 Lakhs today. So, the increase in money is just an illusion. The price rise in the value of goods and services has made sure you are no richer than before.
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Let’s say returns from your investment are 6%. The average inflation was 8% over a 15 year period. Your investment has actually made you poorer and not richer. This is what happens to several million citizens. They believe they are getting rich, but inflation makes sure they stay poor.
Many people consider nominal rate of return to determine the value of investments. They don’t count real rate of return or after-inflation rate of return.
Let’s say you invest in equity mutual funds through SIPs or systematic investment plans for your retirement. You are 30 years old and want Rs 1 Crore at retirement at 55 years. You expect 9% rate of return from the investment. You invest Rs 10,000 a month. Using an SIP calculator the future value of your SIP investment is Rs 1.12 Crores.
But will your retirement corpus be Rs 1 Crore? After considering the impact of inflation, you get just Rs 45 Lakhs. Inflation has eaten up returns and destroyed your money.
The first rule of investing is invest based on risk profile. Investing is all about risk and return. Higher the risk, higher the return. A conservative investor is willing to accept lower return but at lower risk.
Conservative investors generally invest in PPF, FDs, NSC, SCSS or post office schemes. CPI Inflation is around 4% for the month of September. Let’s consider an average inflation of 5%. FDs give returns around 6.25-7% a year. PPF and NSC currently offer 7.9%, SCSS offers 8.6% and post office deposits offer 7-7.7%. These investments give inflation-beating returns.
If you are an aggressive investor, consider equity mutual funds or tax saver mutual funds like ELSS or Equity Linked Savings Scheme. Equity mutual funds could give 8-12% returns a year, easily beating inflation. ELSS is an excellent investment if you fall in the higher tax bracket. ELSS has a lock-in period of 3 years.
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ELSS offers the twin benefits of investment and tax saving. People in the higher tax bracket can save Rs 46,500 a year by investing in ELSS. You can easily earn inflation-beating returns and save tax. Do remember that mutual funds are subject to market risk. Read the offer document carefully before investing.
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