Interest rates on fixed deposit and small savings instruments are showing an upward trend. When investment instruments such as stocks and equity mutual fund schemes are volatile, fixed income instruments become attractive due to low risk and assured returns. While investing their hard-earned money, the common man normally looks at risk, return and liquidity factor, but inflation also plays an equally important role in determining whether the invested corpus would be sufficient to accomplish the goal for which the investment is being made. The returns on equity-oriented schemes, gold and realty investments will fluctuate from day to day, and this therefore gives you a chance to beat the inflation. However, a fixed returns investment provides fixed returns, which reduces your ability to beat the rate of inflation, especially in a period of volatility. Let’s understand how inflation impacts your investment.
Inflation Impact On Investment
Inflation diminishes the purchasing power of money. So higher inflation means greater erosion of your money’s value. For example, you can buy a product at Rs. 100 today. But due to inflation, you may need Rs. 300 or Rs. 500 (assumed) to purchase the same product after 15-20 years. If you do not consider inflation while investing, in the long term you may find it difficult to achieve your key financial goals. For example, while investing for retirement, it is essential to determine how much money you would need after adjusting for inflation. This would help you build an adequate corpus to meet your future expenses. Today, for example, you may need Rs. 5 lakh a year to meet your expenses. But after 20 years, at the prevalent rate of inflation, you may need Rs. 20 lakh a year for the same expenses. So, while investing for a long-term, you must consider real rate of return over the nominal return.
Nominal Return Vs. Real Return
A nominal return is return that an investment offers without adjusting for inflation. On the other hand, real rate of return reflects inflation-adjusted return. Let’s understand this with the help of an example.
Suppose the inflation rate is 4% PA, and one-year FD rate is 7% PA. You invested in the FD for a one-year tenure. In this case, your nominal return would be 7%, but the real rate of return would be only 3% PA (7% minus 4%). It may so happen that the interest rate may increase, but adjusted against inflation, your real returns may increase or decrease. For example, suppose the inflation increases to 6% per annum while the interest rate on the FD increased to 8%, your real return would only be 2% PA.
How To Ensure A High Real Rate of Return
Inflation impacts fixed return instruments more in comparison to equity or real estate. So while you invest in an FD or a small savings scheme, review your portfolio at regular intervals. Sometimes, you may invest in an FD at a particular rate, but sometime later, the bank will increase the rate. In such case, you must evaluate the option of liquidating the existing FD and switching to a higher rate. To mitigate the inflation impact, you can also invest using the FD laddering strategy, i.e. dividing your investment corpus into multiple FDs of different maturities. For example, if you are looking to invest Rs. 5 lakh, then you can invest Rs. 1 lakh each for one year, two years, up to a five-year tenure, i.e., at a gap of one year from each FD. The laddering will ensure liquidity at a regular interval and a steady real rate of return in the long-term. You can also use the laddering strategy to invest in the other fixed return instrument.
Also, depending on your risk appetite and financial goal, you may diversify the investment into other asset classes such as equity and real estate. In the long-term, due to inflation your expenses may rise, but at the same time your income may also increase simultaneously. It is crucial that you step up your investments periodically—preferably annually, as your income increases—and this will help you invest higher and achieve bigger financial goals over the long-term.
The writer is CEO, BankBazaar.com