Inflation and investment planning

There used to be a time when you could buy a piece of candy for around 25 paise. If you were born in the 1970s, you might remember it being even cheaper.

Try buying a candy in a store now, and it won’t be less than a rupee. If you were born in the ’80s, that’s a four-fold rise in the price of a candy. And the clinking change in your pocket is almost worthless.

Try paying with an old 50 paise coin to buy a piece of candy and you’ll most likely be turned away until you pony up a ₹1 coin. This is the impact of inflation on the currency we hold.

In its simplest form, inflation means a rise in prices of things you can buy with your money. It could be because the costs went up, or there is more demand and less supply of what you want to buy. This erodes the purchasing power of money, which could be lying in your savings account, in a fixed deposit or invested in bonds or shares.

Inflation and money

Despite its importance, many investors do not take inflation into account while planning their finances. This is especially critical for arriving at the future corpus that you need to accumulate for your financial goals. Let’s say you want to save for your child’s overseas education in 19 years. The management degree that you hope your child will pursue might cost ₹20 lakh today. You need to factor in inflation to know how much you need to save.

To illustrate the rise in costs, let’s take the average inflation in cost of foreign education as 2 per cent. This was arrived at by using the Income Tax Department’s cost inflation index from 2000-01. Using 2 per cent yearly inflation, the cost of education in 19 years will be around ₹29,13,622. If you ignore inflation, you will fall short of your targeted amount.

Sridevi Ganesh of Chamomile Investment Consultants, an investment advisor, says she usually advises her clients to take a 7.5 per cent inflation expectation for foreign studies, and 10 per cent for education in India.

As you grow older, the cost of medical care, too, goes up. Although health insurance is an essential part of financial planning to insure you against financial shocks when you undergo treatment and hospitalisation, taking a policy early in life, and slowly increasing the sum assured can help take care of inflation in medical costs. Ganesh says it’s very difficult to calculate the inflation in medical costs, but she uses 7.5 per cent as the expected rise in health expenditure. This would obviously vary for people with different ailments in the long run.

Apply the same principle while estimating the amount of regular monthly expenditure that you might need when you retire.

Inflation and returns

The impact of inflation also needs to be factored in while evaluating the returns made by your investments. The real rate of return, which is the return you have earned after excluding the rate of inflation, needs to be considered while computing long-term returns. It is ideal if returns from your investments are higher than the inflation rate; else, the erosion in the purchasing power of money will negate the returns generated.

Say you earned 4 per cent from the amount lying in your savings account over 10 years, but the inflation rate was 5 per cent. In real terms, your rate of return on your savings deposit is -1 per cent. On the other hand, if you earned 12 per cent annually from your equity mutual fund investments over the same period, the real rate of return is 7 per cent. Since investments that can deliver higher real returns typically carry more risk, the choice of investments also depends to a large extent on the risk profile of the investor.