What is Inflation: Meaning and Effects of Inflation

What is Inflation?

Inflation is the decrease in the buying power of the rupee over time. The increase in the average price of goods and services means that you will effectively be able to buy less with your rupee next year than you did today.

Assume you buy a kilo of apples for ₹100. Next year, if prices rise along with inflation, the price for the same kilo of apples might be ₹120. If you save ₹100 from today, you may not be able to buy the same kilo of apples next year. With inflation, you do not lose your money. Its value decreases and eats into your purchasing power.

Warren Buffet once said, “inflation is a far more devastating tax than anything our legislation has enacted”. He added that it has a fantastic ability to consume capital simply. He never lost focus on fear of inflation.

As an investor, neither should you. You should understand the impact inflation will play on your portfolio. When a country’s inflation rises, the monetary policies of a country try to reduce the cash flow in the market. The objective is to reduce consumer spending, and bring back the economy on track.

Because of inflation, there is a need to invest and grow your capital so that you can at least match the purchasing power of your money. Assume you make a plan to invest the same amount of money in stocks, let us see how stock market returns can secure your purchasing power.

Effects of INFLATION on INVESTMENT | ICICI Direct

Additional Read: How to beat inflation with your portfolio

Formula to Calculate Inflation Rate

Suppose you have invested in a stock and got 15% returns in a year and inflation is 6% in that year. In that case, it means your net returns is approximately reduced by 6% and your actual inflation-adjusted return, also known as the real rate of return, can be calculated as:

Inflation adjusted return = (1+ Investment returns)/(1+Inflation)-1s = (1.15/1.06) – 1 = 8.49%

If you want your portfolio to be protected from inflation, your portfolio should earn more than inflation. Ideally, your portfolio not only needs to be adjusted for inflation but also needs to be adjusted for tax. If your tax and inflation-adjusted returns are positive, then only your purchasing power is increasing. Otherwise, you will be earning negative returns on your portfolio. Let’s understand this with a simple example. Suppose you have invested in a bank fixed deposit earning 6% p.a. returns. If you are falling into the 30% tax bracket, your post-tax returns can be calculated as:

Post tax returns = Investment returns* (1 – tax rate) = 6%* (1 - 0.3) = 4.2%

If inflation is 6%, your inflation and tax adjusted return will be (1 + 0.042)/(1+0.06) – 1 = - 1.7% 

It means your purchasing power is decreasing at the rate of 1.7% per annum despite getting a return on your investment. If you want to beat inflation and tax, you should consider investing in equity. However, the equity market will not offer you guaranteed returns, and some risk is involved. You can invest in equity instruments like stocks, mutual funds etc., as per your financial goals and risk appetite.

Commodity stocks like precious metals and energy products might benefit from high inflation. The prices of commodities also rise along with inflation. Because they grow simultaneously, they may provide a good hedge against inflation.

Conclusion

As an investor, you need to understand the factors like inflation that impact the performance of your portfolio. Once you do so, you can invest in suitable asset classes to beat inflation. Whether you invest in equity or precious metals like gold, invest as per your goals, time horizon and risk profile. Some asset classes like equity could be ideal for long-term goals where you are looking for higher returns. On the other hand, some of your goals might be short term and the safety of the money is the priority, then you can choose to invest in safe debt instruments like liquid funds.