What is Inflation? How does inflation affect your Investments?

Do you have any money? Then you really need to understand concept of inflation.Read about it with lots of examples to show how inflation impacts investments
What is inflation and how inflation affects your investments

How does inflation affects your investments? If you have even 100 bucks in the bank or have a pension or PF account or have any other form of investment, you better pay attention. The importance of inflation in investment planning is not given enough importance today.

What is Inflation, how does it work?

Inflation is a concept in economics that measures the purchasing power of money over a period of time. To give a simple example, your grandfather might have bought a lot of land for Rs.2000, 50 years back. Today, you need that much to take your family out for lunch. Maybe even more than 2000 bucks. So, what was worth Rs.2000 at one point of time in the past is worth several 1000 times more than that now.

According to the theory of Inflation, as time goes by, the value of goods increase or decrease(deflation) due to demand, cost, taxes, supply of money etc. In most countries, there is an increase, and this increase in the cost of goods, which results in lower purchasing power of money is called inflation. Inversely, if the value of the goods go down, then it is called deflation.

Let me give you a relatable example to make this very clear.

Let’s say you invest Rs.1,00,000 in a fixed deposit and this is generating you 12% interest per year. That means you get 1% interest per month, which works out to be Rs.100 per month. With this Rs.100, you may be able to buy 1 litre of milk for Rs.50, 3 eggs for Rs.15 and one loaf of bread for Rs.35.

In India, the current annual rate of inflation is at 5% per year. So, two years from now, milk will cost Rs.55, 3 eggs will be Rs.16.5 and one loaf of bread will be Rs.38.5. So two years from now, you will need Rs.110 to buy the same items you are buying for Rs.100 today. However, you will continue to only earn Rs.100 from your Fixed deposit interest.

Why does price of things go up or down?

Well there are three major reasons that have a lot to do with inflation:

  1. Supply of cash: If the government print out a lot of cash and this cash enters the market, the simply put people lot of cash to spend. Yay! Actually, no it is not that good. This means that people will be willing to pay a lot more for anything, meaning sellers will hike up the prices as well. This as it keeps recurring is called Hyper-inflation. Think of Zimbabwe, a cup of coffee costs over a million bucks in their local currency. Serious, a million bucks for a normal cup of coffee. Similarly in post war Germany, hyper-inflation was so bad, people had to carry money in push carts just to buy groceries.
  2. The other reason that pushes inflation is the Demand and Supply of goods. When demand increases the prices too go up making goods costlier gradually. Since there is a genuine need for the goods, people are now willing to pay more for the goods than they were earlier. This ultimately makes the commodity costlier for all.
  3. Similarly, if the supply of something goes up the price drops. Let’s say tomorrow 3D manufacturing drastically improves and 3D building bread out of flour. Then it is going to be really cheap to get bread as companies can churn out bread very fast so they have a lot more to sell. That would mean that there will be a deflation in the cost of bread.

Why inflation is bad for investors and investments?

Actually, it may be good or bad depending on how you have structured your investments. If you have an all cash or mostly cash investment portfolio, it is definitely bad news for you in the long run.

Check out the example I have given further below on two different scenarios when a large sum of money is invested, one in Fixed deposit and other in Real estate. It shows how bad a person with Fixed deposit is hit due to inflation.

Investment options that are impacted negatively due to inflation

  • Cash: The purchasing power of cash you have keeps dropping with the rise in inflation
  • Fixed deposits: The interest you earn and the principal when it matures will all be worth a lot less due to erosion of the value of money
  • Pension, PF, VPF, PPF etc: All funds that provide you a monthly cash payout in the future are impacted
  • ULIPS and Policies that promise a monthly payout or lumpsum payout in the future are impacted

How inflation is good for investments

Not everything about increase in prices is bad. If you happen to have assets that are inflation friendly such as gold, real estate, commodities etc, you should be alright with prices going up.

Let’s look at another example. Let’s say you own a piece of land and you bought it for Rs.1,00,000. Over time, the value of this land will also gradually go up. Likewise, if you have gold, silver, who knows even a barrel of crude oil, the value of all of this will go up with time due to inflation.

Investment options that are impacted positively with inflation

  • Gold, silver and other commodities: As there is a rise in CPI (Consumer Price Index) or WPI (Wholesale Price Index), gold and silver too rise up meaning they are worth more to you later on
  • Dividend paying stocks: As the price of goods rise, the companies you own stocks in too will make more money and pay out a higher dividend
  • Inflation indexed bonds: These are bonds that are linked to and increase with inflation, as it increases the base price of the bond too increases, so you get a higher interest and maturity value
  • Real estate: Value of property increase in line with inflation. So does the income you earn from these properties.

Considering inflation in investment planning

Now we come to the big question. How does inflation affect your investments and what you should do?

Here is how this all ties back to you. For those of you who are planning for retirement or even just looking at investing for the long term this is very important. If you have an all cash and related investments in your portfolio, you will be deeply be impacted by the effects of inflation as time goes by. Gradually, you will be receiving returns which really are of very little value.

Let me give you two examples of Ram and Shyam. Both of them start saving money and retire at the same time with Rs.50,00,000. This is just an example, so don’t look too minutely at the numbers.

Ram: Saves money and put them into Fixed deposit every month. In 2020, he has saved up Rs.50,00,000 and retires. At 8% interest on Fixed deposit, Ram gets a monthly interest of Rs.33,000.
Shyam: Saves money and buys a property for Rs.50,00,000. He rents one floor in the property and lives in the other floor. Gets monthly rent of Rs.15,000 from the property he has rented out.

In 10 years:
Ram: Continues receiving 8% Interest of Rs.33,000. Due to inflation, the value of this money is only Rs.20,000. Additionally, the value of principal of Rs.50,00,000 is now only about Rs.30,00,000
Shyam: Gets an increased rent of Rs.24,000 with time. Additionally, the value of his property too has gone up and now is worth Rs.80,00,000

Balancing between assets to battle inflation

A portfolio that is all real estate, commodity etc may do well in terms of inflation. But it will put you in a hard situation in the short run. Also, these provide much lesser returns and are a lot less liquid. So, look at balancing your investments keeping both short term and long term in mind. Stocks that pay dividends, gold, silver, bonds that are indexed with inflation, real estate are all great ways of safe guarding yourself from rise in prices and erosion of value of money.

Hedging with a multi-region investment approach

If you have the means and are open to exploring, another great option would be to look at multiple geographies. By investing in more than one market or country, you are spreading your risks of inflation across two different country. So if one is hit badly, your investments in the other may be able to still retain more value.

According to IMF

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Abhi is a 29 yr old Indian, on FIRE to retire by 40. He has been investing and learning Finance for the past 12 years. After completing Mechanical engineering, he started working in a multi-national Bank and grew to become an AVP. Currently with an IT MNC as a VP. He lives in Bangalore with his wife and their 1 year old daughter. In his free time, Abhi loves to game on the Xbox, watch movies, read and blog.

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