How Inflation Eats Away into Returns

When you think about investments you are always guided by the inherent returns. When choosing to invest your hard-earned money you primarily think about the returns the instrument would yield and then consider its risk profile. However, when considering returns on your investments, do you ever consider whether the returns are real returns or nominal returns?

Stumped? Most of you are guided by nominal returns and don’t factor in the inflation rate. Since you get returns after a specified tenure, shouldn’t the returns be inflation adjusted?

Inflation, in economic terms, means the general increase in the price of goods and services. Money loses its purchasing power due to inflation. As prices increase, more money is required to buy the same goods and services. Even in the case of investments, inflation leaves its mark. Do you know how inflation affects your investments and eats it away? Let’s understand with an example:

Suppose you need INR 110 for buying a product the next year and you only have INR 100 today. So, you invest INR 100 in an avenue which gives you a return of 10% every year thinking that you would get INR 110 in the next year to buy the product. However, the inflation in the same year is, say, 6%. The product which cost INR 110 this year would cost INR 116.60 in the next year. However, your investment would only grow to INR 110. You would still be short on cash to buy the product. Though the return rate is 10%, the real return which you would be earning would be –

{(1.10/1.06) – 1} * 100 = 3.77% only

Thus, inflation causes your investment return to shrinking as it reduces the value of money. You are, therefore, not able to completely meet your financial obligations for which you invested in the first place.

What can you do?

You cannot stop inflation. Inflation is an economic phenomenon which would be relevant in the market. What you can, however, do, is to invest in avenues which give you inflation adjusted returns. Avenues which give you fixed returns should not be chosen even though the returns are guaranteed. Since the returns would be fixed, they would be stagnant and not increase to factor in inflation. Inflation would, thus, eat into such returns and the real returns would be very low. You should, therefore, invest in avenues where the returns factor in the movements of inflation. Some such avenues include the following –

  • Equity investments

The price of shares moves with the movement in the demand and supply curves. If inflation increases, the prices of shares also increase and as such, you get positive, inflation-adjusted returns from equity investments. The risk factors should, however, be weighed in when investing in equity shares.

  • Mutual funds

Mutual funds are another great avenue to invest your money. These schemes also invest in the market which increases with an increase in inflation. Moreover, through mutual funds, risks are reduced through portfolio diversification and asset allocation. So, if equity shares seem to be a risky choice, you can invest in mutual fund schemes.

  • Gold

Gold is another good ‘investment avenue’ (though we fail to see it is as a meaningful asset) which has consistently given good returns in the face of inflation. Gold is, in fact, considered to be the best way to beat inflation. As inflation increases, the price of gold also increases. The demand, however, does not fall since gold has ornamental and traditional value. So, you ultimately get a positive inflation-adjusted return when you invest in gold. In fact, if track record is an indication, gold has given an annualized return of 13.66% in the last 15 years. This return is double the rate of inflation over the said period. 

  • Real estate

If you have to invest a lump sum fund, real estate can also be a good avenue which would give you returns that are in tune with the inflation rate. Inflation increases the prices of real estate and thus helps in providing a positive return. However, when investing in real estate, liquidity would be a problem. You might not be able to sell off the property to realize cash very easily. This should be kept in mind when investing in real estate for investment purposes.

So, before you choose your investment avenue, consider the real returns yielded by the avenue. Real returns are returns which are inflation adjusted. Real returns show you the worth of your investments after factoring in inflation. Since inflation is a termite which eats into your portfolio, ensure that your portfolio is inflation proof.