Educating Investors

Effect of Inflation on Investments4 min read

First of all, it is imperative to understand the term ‘Inflation’? 

Let’s take the example of some food. Do you remember the price of the famous vada pav near your college when you had it for the first time? What is the cost of the same vada pav today? Well, it has undoubtedly increased every year. That’s the work of ‘Inflation’. Inflation is the general increase in the prices of goods and services in the economy over time. 

The primary effects of Inflation are on the purchasing power and cost of borrowing. 

Inflation in India has been around 6 percent per annum. This implies that any commodity would cost 6 percent more after a year. Comparing it to the bank savings rate, which is 4 percent currently, Inflation creates a more significant impact on the purchasing power kept in the saving bank account. This implies that a deposit of INR 100 in a savings bank would become INR 104 after one year as against the cost of the commodity becoming INR 106 after one year because of Inflation.

Conclusion: If at any time your savings don’t grow at the same rate as Inflation, you are effectively losing the real value of money.

Robert Orben once said that Inflation is the crabgrass in your savings.

The only way to beat the effect of Inflation is to invest your savings for a better return than you can get in savings accounts (i.e. return higher than inflation). An inflation hedge typically involves investing in an asset expected to maintain or increase its value over a specified period.

What are the investment avenues to beat the effect of Inflation?

  1. Mutual funds

One of the less risky investment options is building a portfolio of Mutual funds for new investors. To create the best portfolio of mutual funds, you must go beyond the sage advice, “Don’t put all your eggs in one basket:” Mutual funds accurately helps you with the benefit of adequate diversification.  In case of lack of knowledge, mutual funds are one of the most excellent investment options as professional experts manage them. 

2. Direct equity

Investing in direct equity means buying shares of a company – becoming a part-owner of that company. Being a shareholder of a company means partly chipping into the ownership of the company. Thus, as a part-owner of the company, one is entitled to the associated business risks as well as the share in profits and growth of the company. Warren Buffet once said, “Wide diversification is only required when investors do not understand what they are doing”. Equity investments have been considered the riskiest investments out of the other investment avenues, thereby, has been instrumental in yielding above than average returns. 

3.   Hard assets / Commodities

One can even prefer investing in Hard assets, i.e. commodities like Gold. When Inflation rises, the prices of hard assets and commodities rise along with it. Another benefit of investing in these hard assets is that they typically are less correlated to the overall market. Therefore, Gold is a seamless hedge to the overall equity portfolio because of its inverse relationship with the equity markets.

4.   Inflation-Indexed Bonds.

Another investment option for further lower risk is ‘Inflation-Indexed Bonds’ where the bond return is at par with the inflation rate in the country, thereby providing a perfect hedge to the rising Inflation.  As the name suggests, the yield of such bonds is adjusted as per the actual rate of Inflation. 

5.   Real estate.

Real estate investments (similar to Gold) are considered as a good hedge against Inflation since the property values and rental income typically increase along with the Inflation. Allocation to real estate can be an excellent diversification to the overall portfolio risk. The main problems with real estate are lack of liquidity, higher capital investments, more extended time frame and limited leverage. 

To conclude, Inflation affects every rupee earned. Therefore, every individual should reassess their investment policy statement, asset allocation and overall risk of the portfolio to map it with the long term aspirations and goals keeping in mind the overall effect of Inflation in the long run.

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