Gone are the days when a penny saved was penny earned. Thanks to inflation, it reduces purchasing power of money.
Impact of inflation on your portfolio depends on the type of securities you hold. The price of fixed income securities is inversely proportional to the interest rate. And depending on the inflation, the Reserve Bank of India monitors interest rates. Most of the fixed income securities carry interest rate risk that is the change in value of the investment based on the changes in the interest rates.
Inflation is an increase in cost of living on a yearly basis. Say for example, if inflation is 10%, then a good which was sold for Rs 100 previous year will now cost Rs 110. So one needs to make investment decision based on the inflation of the country, which is dependent on number of factors such as economy, GDP etc.
Let us see how inflation can erode your investments:
Say, Rahul invests Rs.1,00,000 in a bank FD fetching him 12% interest rate on yearly basis. Rahul is in a income tax bracket of 20 %. At the end of one year, he gets back Rs.1,12,000 and he pays 20% of 12,000 as tax.
Invested Amount =Rs 1,00,000
Maturity Amount =Rs 1,12,000
Interest Earned =Rs 12,000
Tax on Interest @ 20 per cent = 2,200
Amount in Hand = Rs 1,09,800
Interest Earned = (9,800/1,00,000) * 100
= 9.8 per cent
If inflation is at 8 per cent, then the formula is Real rate of return/Inflation adjusted return
= 9.8 per cent - 8 per cent
= 1.8% per cent
Means that your investment has increased by 1.8 per cent only.
How we can reduce cost of inflation from our investments?
This is where diversification helps, if Rahul had diversified in investment through different avenues such as equities, he may have got better returns.
Let us consider another example where Rahul invest half investment in equity and another half in debt.
Investing in debt
Amount to be invested = Rs 1,00,000
Amount invested in equity = Rs 50,000
Amount invested in debt = Rs 50,000
Interest earned in debt = 12 per cent which will be 6000
Tax Slab = 20 per cent (or) 1200
Interest earned - tax = 4,800
Investing in equity
Interest earned in equity = 20 per cent (or) 10,000
Total Interest Earned = 14,400 (or) 14.4 per cent
Inflation = 8 per cent
In this case rate of return will
= 14.4 per cent - 8 per cent
= 6.4 per cent
Just by allocating in two different sectors the return increased from 1.8 per cent to 6.4 per cent. However, this is just an assumption/illustration, investing also depends on number of factors such as age of investor and his risk taking capacity and tenure of the investment. Remember, we have just indicated profits from equities, there is no guarantee that you may earn profits.