Thinkinvestor. Risk of inflation matters

Bank fixed deposits are an important part of an individual’s goal-based investments. But many individuals have two concerns relating to bank deposits. One, that bank deposits offer low post-tax returns. And two, that post-tax returns on such deposits do not typically beat inflation. Previously, we discussed the first issue and showed why bank deposits are crucial despite low post-tax returns. In this article, we discuss how to understand inflation in relation to bank deposits.

Inflated-adjusted goals

Suppose you want to create a fund for a child’s college education. The right way to save for the goal is to estimate the education cost when your child is likely to enter college, say, eight years hence. So, you must consider today’s education cost and adjust it for education inflation for eight years. Next, you must consider how much of your savings set aside for this goal must be allocated towards equity funds and bank deposits. Having incorporated inflation into your goal, you do not have to be concerned that bank deposits do not beat inflation; deposits are meant to provide stable returns, not beat inflation.

The higher expected return on equity is likely to balance the lower expected return on bank deposits.

What about the effect of inflation when you are investing your surplus savings? Inflation is relevant when we intentionally postpone consumption to an immediate future date. Suppose you postpone your vacation by a year and the travel cost is expected to rise by 10 per cent. Inflation will hurt you if you park your vacation savings in a one-year deposit. But with surplus cash, your objective is to earn a return on savings. Think of the difference between the post-tax return on your deposit (say 5 per cent) and the general inflation (say 5.5 per cent) as the “real” price you must pay to prevent yourself from spending the money today!

Conclusion

Your concern should be about inflation risk, not that post-tax returns on bank deposits can be lower than inflation; for inflation risk impacts the likelihood that you will achieve your life goals. This is the risk that actual inflation could be higher than the inflation assumed (expected inflation) to determine the amount required to achieve a life goal. As our markets evolve and new products are developed, inflation-linked investments may be available to manage inflation risk associated with your life goals. Till then, be mindful of inflation risk on your investments.

(The author offers training programs for individuals to manage their personal investments)

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