How Inflation Eats Into Your Returns

India’s retail inflation rose by 7.79 per cent on an annual basis in April, as per the latest data released by the Ministry of Statistics and Programme Implementation (MoSPI). Incidentally, inflation in food items rose even higher to 8.38 per cent, according to MoSPI’s Consumer Food Price Index. While the effect of inflation on food is immediately evident, it has a substantial impact on returns as well, which may become visible only later.

How Inflation Affects Returns 

“Inflation reduces the purchasing power of your money. In simple terms, if you could buy 20 lemons for Rs 100 a few months ago and now only 10, the value of your money has reduced by half as you can buy only half of what you could with the same amount of money. Returns from investments are impacted by the erosion of the money value,” says Adhil Shetty, CEO, Bankbazaar.com.

This is true for all investments. Consider fixed deposits (FDs), for instance. FD rates are at present in the range of 5-5.5 per cent per year. This means that for every Rs 1,000 that you deposit, you get Rs 1,050, or Rs 50 extra. Now, if the price of lemons when you deposited the Rs 1,000 was Rs 5, you could buy 200 lemons for the money then. However, with inflation at 7 per cent, at the end of the year, the price of lemons has become Rs 5.35. So, at the end of the year, despite having Rs 1,050, you would be able to buy only 196 lemons. This means that despite earning an interest on your investment, the value of the money has fallen.

The other threat of inflation is that returns from investments can actually turn negative. In the above example, if the rate of return of FDs is 5 per cent per annum, and the inflation is 7 per cent per annum, the real rate of return is -1.87 per cent per annum, which essentially means that you are losing money.

Inflation-Proofing Your Long-Term Investments  

An investor must focus on creating a diversified portfolio to beat inflation in the long term. “To grow in real terms, the overall portfolio should beat inflation in the long term. A diversified portfolio spread appropriately across equity, debt and other asset classes is ideal to beat inflation. Therefore, we shouldn't be worried about a particular instrument beating the current inflation rates,” says Chenthil Iyer, founder, and chief strategist, Horus Financial Consultants.

The high inflation rates is owing to high prices of fuel, commodities and food items. However a spike in the crude prices along with the tax rate on fuel has created a snowball effect of inflation. “This is a temporary phenomenon and hence can be reversed if, say, the taxes are lowered. In short, an investor must focus on creating a diversified portfolio and hence beat inflation in the long term instead of worrying about what's happening in the short term,” adds Iyer.

In addition to that, one must pay attention to the real returns, which are the post-inflation returns. An investment that is considered safe but gives negative real returns may not be suitable for the long term. For instance, if an investor’s entire retirement funds are in, say, FDs, the real returns could be negative in the long run and the person will not have a sufficient corpus when needed. Therefore, one must consider real-returns as well as the risk while selecting an investment avenue.