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Meaning of Inflation & How Does it Affect your returns

If your investment returns are not able to beat inflation in the long run, it can jeopardise your financial goals. In this article, we will understand the meaning of inflation and how does it affect your returns.
Inflation and how does it affect your returns

Meaning of inflation

As a consumer, you must have experienced an increase in the prices of various goods and services over a period of time. For example, petrol used to cost around Rs. 70-80 a litre, a couple of years back and today it costs more than Rs. 100 a litre. Similarly, you must have experienced an increase in the prices of fruits, vegetables, milk, movie tickets, children’s school fees, healthcare services, etc. The increase in the prices of various goods and services is nothing but inflation. In this article, we will understand the meaning of inflation and how does it affect your returns.

Inflation is the general trend of an increase in the price of various goods and services. It is measured on a year-on-year basis. With the increase in annual inflation, you will need more money to buy the same quantity of the product or service next year. For example, milk was costing Rs. 50 a litre last year and it is costing Rs. 55 a litre this year. It means to buy the same one litre of milk this year, you will have to pay 10% more than last year. It means milk inflation is 10% on a year-on-year (Y-o-Y) basis.

As seen from the above table, the annual prices of most food products have gone up with every passing year. It means you have to shell out more and more money to buy the same food products with every passing year. Hence, you need to earn more money with every passing year, or your investments need to earn a higher return than inflation to sustain the same standard of living.

How does inflation affect your investment returns?

As an investor, you should always consider your investment returns after considering the effect of inflation. For example, today (as of July 2021) the SBI 1-year fixed deposit pays 5% p.a. The June 2021 inflation rate based on Consumer Price Index (CPI) is at 6.26%. In this case, if you keep Rs. 10,000 in a fixed deposit, at the end of 1 year, you will get Rs. 10,500.

Let us assume that next year also, inflation continues to be at 6.26%. The goods that cost Rs. 10,000 this year will cost Rs. 10,626 next year. Your fixed deposit investment will give your Rs. 10,500. So you will have to put an additional Rs. 126 (10,500 – 10,626) from your pocket to maintain the same standard of living as last year. In this way, if inflation is running higher than your investment returns, your money will lose purchasing power. Hence, as an investor, you should always aim at earning inflation-adjusted returns.

As seen in the above image, inflation eats into your returns.

For example, the SBI 1-year fixed deposit gives you a nominal return of 5% p.a. Inflation is running at 6.26% p.a.

So your real return is -1.26% (6.26% - 5%)

In the above example, when inflation is higher than the nominal rate of return, you have not made any money. In fact, you have lost money as you have to pay money from your pocket to maintain the same standard of living as last year. High inflation has eroded the purchasing power of your money.

How inflation can impact your goal planning?

If your investment returns are not able to beat inflation in the long run, it can jeopardise your financial goals. Let us understand this with the help of an example.

Mohan’s son Pradeep is 15 years old. Pradeep will be going for his post-graduation at the age of 20 years. The course that Pradeep plans to go for costs Rs. 10 lakhs as of today. Mohan has received Rs. 10 lakhs as maturity proceeds from an insurance policy. So, he has already accumulated Rs. 10 lakhs for Pradeep’s post-graduation as of today.

In the next 5 years, education inflation is expected to be at 10% p.a. So, the education course costing Rs. 10 lakhs today is expected to cost Rs. 16,10,510 after 5 years considering the annual inflation of 10%. Mohan is thinking about how and where to invest the Rs. 10 lakhs that he has in hand. Let us consider the various investment options for Mohan and how inflation can impact Mohan’s financial goal of Pradeep’s higher education.

Investment productExpected investment growth rate (CAGR)Future value of investment (Rs. 10 lakhs)Future cost of education courseImpact of inflation on financial goal
Bank savings account3%₹ 11,59,274₹ 16,10,510₹ -4,51,236
Bank fixed deposit5%₹ 12,76,282₹ 16,10,510₹ -3,34,228
Hybrid debt fund8%₹ 14,69,328₹ 16,10,510₹ -1,41,182
Hybrid equity fund10%₹ 16,10,510₹ 16,10,510₹ 0
Large-cap equity fund12%₹ 17,62,342₹ 16,10,510₹ 1,51,832
Mid-cap equity fund14%₹ 19,25,415₹ 16,10,510₹ 3,14,905

As seen from the above table, a course that costs Rs. 10 lakhs today will cost Rs. 16.10 lakhs in 5 years if education inflation is 10% p.a. Mohan needs to invest his money for the next 5 years in such a way that the investment returns are higher than inflation. If the returns are lower than inflation, then he will have to put money from his pocket.

Following is the analysis of the above table data:

  1. If Mohan keeps the money in a savings account earning 3% p.a., he will have Rs. 11.59 lakhs in 5 years. His requirement will be Rs. 16.10 lakhs. So, he will have a shortfall of Rs. 4.51 lakhs which he will have to pay from his pocket.
  2. If Mohan invests the money in a bank fixed deposit earning 5% p.a., he will have Rs. 12.76 lakhs in 5 years. His requirement will be Rs. 16.10 lakhs. So, he will have a shortfall of Rs. 3.34 lakhs which he will have to pay from his pocket.
  3. If Mohan invests the money in a hybrid debt fund with an expected return of 8% p.a., he will have Rs. 14.69 lakhs in 5 years. His requirement will be Rs. 16.10 lakhs. So, he will have a shortfall of Rs. 1.41 lakhs which he will have to pay from his pocket.
  4. If Mohan invests the money in a hybrid equity fund with an expected return of 10% p.a., he will have Rs. 16.10 lakhs in 5 years. He will be able to meet his requirement of Rs. 16.10 lakhs. So, he will not have to pay anything from his pocket.
  5. If Mohan invests the money in a large-cap equity fund with an expected return of 12% p.a., he will have Rs. 17.62 lakhs in 5 years. His requirement will be Rs. 16.10 lakhs. So, his investment has earned an inflation-beating higher return, and he will have a surplus of Rs. 1.51 lakhs.
  6. If Mohan invests the money in a mid-cap equity fund with an expected return of 14% p.a., he will have Rs. 19.25 lakhs in 5 years. His requirement will be Rs. 16.10 lakhs. So, his investment has earned an inflation-beating higher return, and he will have a surplus of Rs. 3.14 lakhs.

Equity mutual funds have the potential to give inflation-beating high returns

In the above example, we saw how equities have the potential to give inflation-beating high returns. Let us check the actual data to see the kind of returns that diversified equity mutual funds have given in the past.

Fund nameAUM (in Rs. crores)Returns (%)
1 year3 years5 years
Quant Active Fund73693.0328.6223.05
Nippon India Small Cap Fund15353110.6223.8822.25
SBI Small Cap Fund909184.5223.4821.86
Quant Small Cap Fund700166.5134.1721.59
Axis Small Cap Fund600887.2827.3320.97
Mirae Asset Emerging Bluechip Fund1867562.4423.1320.90
Parag Parikh Flexi Cap Fund1136058.1022.6220.78
Kotak Small Cap Fund4765117.4126.7620.09
Axis Midcap Fund1281261.2321.0419.45
PGIM India Midcap Opportunities Fund195293.3626.3619.29

Note: The returns are as of 24th July 2021. One-year returns are annualised, and three and five-year returns are CAGR. The mutual funds have been ranked based on five-year returns. Diversified equity funds with a minimum AUM of Rs. 500 crores have been considered.

As seen from the above table, diversified equity mutual funds have given inflation-beating high returns in the last 5 years. They have the potential to do that in the future also.

Asset allocation should be the core of your goal planning

While equity mutual funds should be a part of your investment portfolio, it is important to follow appropriate asset allocation to achieve your financial goals. You can plan and systematically invest towards your financial goals with Glide Invest. You will get guidance for:

  1. A personalised risk profile assessment
  2. Identifying your financial goals
  3. Appropriate asset allocation
  4. Making a financial plan for each goal
  5. Automating the financial plan
  6. Review and analysis of your financial plan 
  7. Hand holding you till your financial goals are achieved

To start investing towards your financial goals, download the Glide Invest App now from Google Play Store or Apple App Store and get started.

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