How Inflation Affects Your Financial Goals

Inflation – Decrease in value of money and rise in the price of cost of living over time. Suppose the rate of inflation is 5.5 %, what we are buying today for Rs. 100/- will cost Rs. 105.50/- next year. As inflation rises every rupee will buy a lower quantity of cost of living. But does the income increase as per inflation. Thus if we are saving for future, we should consider those scheme which suppose to deliver inflation beating returns. Inflation not only affects returns rather it affects the overall economy. Relationship between inflation and investment is essential for informed investing decision.

To dustup inflation, avoid keeping your money idle in cash, or in Saving Account which offer minimal interest in real term. Rather invest money in investment options where returns from investments are higher than inflation. Investment wisely will help you to overcome the problem of inflation and will help you to achieve your financial goals successfully.

How inflation affects investment returns

Let’s try to understand the concept of “nominal interest rate” and “real interest rate” before how inflation affects investment returns.

Nominal Interest Rate – The nominal interest rate denotes the rate that the bond issuer pay to the bond holder and generally the rate is stated in the bond itself as Coupon Rate, without any adjustment with inflation. As a result inflation reduces purchasing power of money.

Real Interest Rate – The nominal interest rate adjusted for inflation is called Real Interest Rate. In order to understand the real growth of money for the bond holder the nominal interest rate has to be adjusted with inflation.

Only when the nominal returns surpass inflation, investor earns a real return.

For example, if the nominal interest rate on a bond is 9% and the inflation rate is 6%, then the real interest rate will be around 3%. Therefore, if the rate of inflation exceeds the coupon rate of a bond, the real interest rate on the bond will be negative.

How inflation affects fixed income investment

Generally investors buy fixed income securities, as they want stable income in the form of interest payment. Although the income stream remain the same on most of the bond until maturity, the purchasing power of interest payment decline as inflation rise. As a result bond prices tend to fall when inflation rise.

But investments like Real Estate, Commodity and Stock may protect from inflation. Price of Real estate and gold are seen useful to protect against inflation, as their prices goes up at the time of inflation. On the other hand when you buy shares, you own a small ownership of that particular company. When the price of goods and services increases, Company makes more profit and this may cause stock price to go up and investor to make more money from the price of the shares and dividends.

How to Beat Inflation Effectively

Invest in Capital market – Capital market have historically outperformed inflation over the long term. One can directly invest in capital market, which is not at all advisable for beginners as capital market is riskier but capital market linked equity products are there with mutual funds scheme. If one opt so can invest in equity through mutual fund, if economy experience inflation, the capital market will grow. The return from the capital market offers real return on investment and help to beat inflation. Equity involves market risk, but a disciplined and long term approach may manage volatility.

Diversify Portfolio – There are various factors while diversifying portfolio, a balanced portfolio may include equity for growth, debt instrument for stability and gold as a hedge against uncertainty. Such combination protects portfolio from different market conditions.

Consider Real Return – Consider return on investment based on real return and not on nominal returns, real returns are calculated after considering inflation. Evaluation based on real return depicts how money is growing.

Increase Investment – keep investing growing as and when yours income grow.

Conclusion

Invest money, where returns from investments are higher than inflation. Invest in capital market not directly but in capital market linked equity products with mutual funds scheme, diversify portfolio and a balanced portfolio is combination of equity, debt and gold. Always consider real return and not the notional return, along with keep growing your investment as yours incomes grow.