In simple terms, inflation is a situation where there is a rise in the general level of prices of goods and services. Or if you look from the other side, the value of your currency keeps decreasing, and hence, you need more of it to buy the same quantity of goods. Inflation is not totally avoidable in a country due to many reasons. Governments do their best to keep things in control but still, there will be rise in the level of prices all over the world. In India, we experience an average inflation level of 8% per annum. That is, the general level of price of goods and services in India increases by 8% on an average.
Now, let’s take a simple example to show how you’d get hit by inflation-
The birthday bash.
Your wife just gave birth to a sweet baby girl. One year from now, you are supposed to celebrate her first birthday. To make a budget, you enquire at an event management group about the costs and they say it would cost one lakh right now but they cannot guarantee the same price 1 year down the lane, because the cost of materials can go up. So you immediately put this money in a deposit that would give you 8% return by the year end. At the end of year 1, you have 108,000 with you.
Now, one year has passed and you have to celebrate your baby’s birthday. Let’s assume that the inflation during the year was at 10%. That means the general price levels of all products have risen by 10% and hence your event manager is going to bill you a minimum of Rs 110,000 for a party instead of 100,000 earlier. So to arrange a party now, you have to incur an additional expense of 2,000 from your pocket. Why? Because, the money you have, has lost its value to the extent of 2,000. And, you could manage to make a return of only 8,000. If the price levels keep moving up at this rate, it would cost you more than 2.60 lakhs to host your daughter’s 10th birthday! Had you managed your money to get a return of 10%, you wouldn’t have to spend that additional 2000 from your pocket.
That’s inflation for you – try to understand this vital principle in order to manage your money. So, if you are getting 8% on a 10 lakh Fixed Deposit and if the inflation rate is 8%, do you think you have gained a penny? – No. The return you earned is ‘0’. The interest earned is taxable. So there is no real return from this investment. It has resulted in a loss.
How does inflation affect investments?
Fixed income instruments – Since fixed income investments are locked into a particular interest rate, your earnings may not keep up should the inflation rate accelerate. The principal you have invested also deteriorates in value if inflation rises steadily over a period of time.
For example -Lets assume that your tax rate is 20%. If you invest 2, 50,000 that gives you 10% return, you will get 25,000 as return from which you will have to pay 20% tax .
- Amount Invested = 2,50,000
- Maturity Amount = 2,75,000
- Interest Earned = 25,000
- Tax on Interest @ 20% = 5,000
- Net Amount in Hand = 2,70,000
- Interest Earned = (20,000/2,50,000) * 100 = 8%
- If the inflation prevailing is 7%, then Real rate of return/Inflation adjusted return = 8% – 7%= 1%
This implies that the value of money in your hand has increased only by 1% and not by 10% or 8% although you were under the impression that you were earning 10% on your investments. You have to be aware of this illusion.
Stock market investments- Inflation and stock markets are negatively co-related. When inflation is high, it hinders economic growth of the country and such a scenario would definitely affect stock prices negatively. So as inflation increases, stocks tend to perform poorly.
Gold and silver investments –.The reverse would happen to gold and silver. Since stocks are not attractive, investors would naturally resort to gold and silver which are safe havens. The reason is that, as inflation begins to creep up, the purchasing power of paper currency loses it value. Once paper currency has been invested into this precious metal, it will not lose its value as a result of inflation. Hence, the prices of gold and silver would increase when there is inflation.
Does that mean Investments in gold is a protection against inflation? –
Yes, for the time being. We will show you how with an example-
Let’s assume that you have Rs 1000 in currency. Inflation is at 8 % and hence at the end of the year, your 1000 is worth only 920. Instead, let’s assume that you bought gold. That move will protect your currency from losing value. How? When inflation goes up, the demand for safer havens such as gold will also increase (at least at the rate of inflation). Hence, if inflation rate is 8%, the gold prices will also move up by 8% approximately.
In such a scenario, your 1000 invested in gold is now worth 1080 whereas if the money were held in cash, it would have lost its value to 920. So when you invest in gold, you maintain the purchasing power at the same level. Heavy investments in gold can be considered as a warning sign that inflation is coming. (Definitely, there are alternative theories that explain why Gold investments may not be a safe bet in the long term)
The government attempts to control inflation by altering the interest rates. Interest is another vital concept, the knowledge if which, is absolutely necessary to take financial decisions and comparisons. We talk about interest rates in the next post.
Inflation is an all round concept you cannot miss. The rate of inflation and the taxes you pay on returns have to be accounted for while measuring returns.