Inflation Affecting Investment
In the early units of our module, we have discussed how inflation makes everything costlier with passing the time. Hence we need to invest our funds in high yielding assets to counter this evil. So, in this section, we will discuss how inflation affects our investments.
Purchasing power is the quantity of goods or services that one unit of money can buy. For example, ₹100 can purchase much less today than it could purchase say 20 years ago. If your income level stays the same, but the prices of goods or services increase, then it essentially means that the purchasing power of your income has reduced. This increase in the price level with the simultaneous fall in our purchasing power is called Inflation.
Inflation is one of the most important factors to account for when you are making your financial plan.
Let us understand how it affects our investments through a case study-
You are going to retire 20 years from now. Let’s see what happens if you invest in instruments that don’t match or beat inflation. Let’s take a figure of ₹10,000. Assume an inflation rate of 10% and take a time period of 20 years. As per the formula given for calculating the future value of money in the previous section, in 20 years, you will need a figure of ₹67,275 to have the same purchasing power as your ₹10,000 today.
You have 3 choices of where to invest your ₹10,000 today –
- A bank savings account
- A debt mutual fund
- An equity mutual fund
Let’s see how each one fares against an inflation rate of 10%.
The amount you require to simply keep the purchasing power of your money constant is ₹67,275, but the inflation at 10% has eaten into the value of your money so much that over 20 years, even investing in a debt product at 7.50% p.a. is not enough.
You need to earn at least 10% every year to just match inflation and keep the purchasing power of your money intact.
In the table above, it is only equity that’s earning 15% p.a., that matches and beats inflation.
You can also match and beat inflation by investing into a mix of equity and debt instruments i.e., diversifying your investments across different asset classes, which is why asset allocation is an important concept to understand.
Now that you know are aware of the basic idea of investing and why is it important? It is time to create a full-proof plan to achieve our financial goals at different stages in our life. So, from the next section onwards we will dig deep into world financial planning.