Inflation, Savings & Investment
In this article, we will learn about the relationship between inflation, savings, and investment. We will understand how inflation erodes the value of your savings over time and how you can invest your savings for your financial goals to get inflation-beating returns. Let us start with understanding the concept of inflation.
What is inflation?
Inflation is the general increase in the price of goods and services over time. For example, a litre of milk cost Rs. 50 last year, and this year it costs Rs. 55. So, the 10% increase in the price of milk is the effect of inflation. Inflation, or a price increase, usually happens due to a mismatch in demand and supply. If the demand for a particular product is more than its supply, its price goes up. In short, it is more people/more money chasing a few units of a product, thus driving up the price.
Impact of inflation on savings and investments
Inflation silently erodes the purchasing power of your money without you realising it. For example, Ramesh has accumulated Rs. 1 lakh for his daughter Tina’s fashion designing course, for which she will take admission next year. As Tina will be taking admission for the course next year, Ramesh can keep the amount of Rs. 1 lakh as cash at home, or in a savings account that pays 3.5% interest p.a., or in a 1 year fixed deposit that pays 6% p.a.
Next year, due to inflation, the institute increases the course price by 10% to Rs. 1.1 lakh. Let us understand how did inflation impact Ramesh in different scenarios:
- Cash: Let us assume that Ramesh kept the admission fee amount of Rs. 1 lakh as cash at home. In this case, while paying Tina’s admission fee of Rs. 1.1 lakh, Ramesh will have to put an additional Rs. 10,000 more than the Rs. 1 lakh that he had accumulated last year. So, in this case, inflation eroded the purchasing power of Ramesh’s cash amount of Rs. 1 lakh by 10%.
- Savings: Let us assume Ramesh parked the admission fee amount of Rs. 1 lakh in his savings account that pays 3.5% interest p.a. instead of keeping the cash at home. At the end of 1 year, Ramesh’s Rs. 1 lakh will grow to Rs. 1,03,500. In this case, while paying Tina’s admission fee of Rs. 1.1 lakh, Ramesh will still have to put an additional Rs. 6,500 from his pocket over and above the Rs. 1,03,500 that he has accumulated in his savings account. So, in this case, inflation eroded the purchasing power of Ramesh’s savings account balance of Rs. 1,03,500 by 6.5%.
- Investments: Let us assume Ramesh invested the admission fee amount of Rs. 1 lakh in a 1 year bank fixed deposit that pays 6% interest p.a. instead of parking the money in a savings bank account. At the end of 1 year, Ramesh’s Rs. 1 lakh will grow to Rs. 1,06,000. In this case, while paying Tina’s admission fee of Rs. 1.1 lakh, Ramesh will still have to put an additional Rs. 4,000 from his pocket over and above the Rs. 1,06,000 that he received as maturity proceeds from his 1 year fixed deposit. So, in this case, inflation eroded the purchasing power of Ramesh’s fixed deposit maturity amount of Rs. 1,06,000 by 4%.
The interest amount earned on fixed deposits is taxable. So depending on the tax bracket that Ramesh falls in, his actual returns from the fixed deposit will be lower than 6%.
Important note: for savings accounts and fixed deposits, banks compound interest quarterly. But, for simplicity of understanding, we have considered annual compounding in the above example.
Inflation-adjusted returns on savings & investments
In the above example, you will notice that Ramesh’s investment did see positive growth of 3.5% in the case of the savings account and 6% in the case of fixed deposit. However, as inflation was at 10%, it harmed Ramesh’s returns from the savings account and fixed deposit. So, the key takeaway here is, you should always calculate your investment returns after factoring in inflation, known as inflation-adjusted returns or the real rate of return.
In the above example, the real rate of return after considering the impact of 10% inflation is:
- -6.5% when the money was parked in a savings account
- -4% when the money was invested in a fixed deposit
You will be surprised to see how a 10% inflation rate resulted in:
- Ramesh’s 3.5% positive growth rate from the savings account finally ending in 6.5% negative returns on a net basis.
- Ramesh’s 6% positive growth rate from fixed deposit finally ending in 4% negative returns on a net basis.
This is how inflation erodes the value or purchasing power of your money over time. Hence, while making investments for your financial goals, you should always consider inflation-beating returns.
However, it is essential to note that it made sense for Ramesh to invest his money in a fixed deposit because the money was required after 1 year for Tina’s course. For such a short period, investing in equity or gold would be risky as these asset classes are volatile. Hence, to protect the value of capital, investing in liquid mutual funds or fixed deposits is fine for short periods. For long-term investments, and asset allocation mix of equity mutual funds, gold, and fixed income products is ideal.
Ways to counter inflation and generate inflation-beating returns
During periods of high inflation, parking money in a savings account or investing in a fixed deposit or debt mutual fund will lead to negative returns if the inflation rate is higher than the rate of return from these products. Hence, for long-term financial goals, you should do goal planning. Let us understand this with the help of an example.
Karan wants to build a higher education fund for her 2-year-old daughter Shruti. Karan has enquired about some courses in various streams such as MBA, engineering and some others. The costliest course costs Rs. 20 lakhs as of today. Shruti will go for her higher education when she completes 21 years old.
Karan has 19 years to plan and build a higher education fund for Tina. Karan is expecting education inflation of 10% during these years. A course that costs Rs. 20 lakhs as of today will cost a whopping Rs. 1,22,31,818 (Rs. 1.22 crores) if the cost of education (inflation) goes up by 10% every year for the next 19 years.
Diagram: Increase in education cost in 19 years @ 10% annual inflation
The above chart shows how the current cost of education of Rs. 22 lakhs will grow to Rs. 1.22 crores in 19 years, at an annual inflation rate of 10%.
While the amount of Rs. 1.22 crore will look like a huge number; Karan has 19 years to plan for this financial goal. With an appropriate asset allocation (mix of equity mutual funds, fixed income products and gold) and an expected 12% CAGR, Karan can accumulate the education fund by investing Rs. 1,72,152 annually or Rs. 14,346 per month.
Diagram: Increase in education cost and building the education corpus
The above chart shows how an annual investment of Rs. 1,72,152 (monthly Rs. 14,346) will grow to Rs. 1.22 crores in 19 years, at a CAGR of 12%. Even though the chart shows a linear growth of 12% annually, in real life, markets are volatile. So, there will be outstanding growth in some years, a mediocre growth rate in some years, and there will be negative growth in some years.
Goal planning with Glide Invest
In the above example, we saw how Karan could calculate the future cost of his financial goal after factoring in inflation. We also saw how Karan could make a financial plan for his goal and generate inflation-beating returns. If you also wish to do goal planning and generate inflation-beating returns, you can do it with Glide Invest.
In the 21st century, technology has played a vital role in shaping up how we conduct our financial affairs. Today you can open up your phone and tap a few buttons to plan and systematically invest towards your financial goals with Glide Invest. You will get guidance for:
- A personalised risk profile assessment
- Identifying your financial goals
- Appropriate asset allocation
- Making a financial plan for each goal
- Automating the financial plan
- Review and analysis of your financial plan
- Hand holding you till your financial goals are achieved