If you are planning to make an investment anytime soon, the first thing that you need to consider is the rate of return you will get on your chosen instrument. Novice investors often make rash investment decisions by getting swayed away by “promises” of doubling or tripling their money. It’s superlatively critical to factor in the time your money will stay invested in an instrument, and how two external factors — namely tax and inflation — will impact your investment returns.
On closer scrutiny, you will realise that the value of your investments might get diminished once you analyse the returns through the prism of tax and inflation. When you do so, you take into the account what is called the real rate of return on your investment.
For example, if your savings bank account is paying you an interest rate of 4% in, say, 2018, while the annual inflation rate during the same year is 3%, the real rate of return will be (nominal interest rate of 4% – inflation rate of 3% =) 1%. Not 4%.
Evaluating the real rate of returns puts us in a better position while laying out our investment strategy to meet our short and long-term financial goals in time.
Let’s take another example to understand this better.
Let’s say, you plan to buy gold and decide to open a recurring deposit to put away Rs.10,000 each month to save for the same. If the bank offers an interest rate of 6.9% per annum, by the end of 1 year, you would have accumulated Rs.1,24,554. However, after one year, prices would have increased overall due to general inflation and other external factors. Let’s assume this increase could be by 2.5%. This means that the total interest that you gain will be lesser by this percentage. So, you will gain at the rate of only (6.9%-2.5%=) 4.4%. Again, not 6.9%.
Let us now take a look at how this will affect different types of investments:
Fixed deposits: These are very popular investment instruments primarily because of fixed returns that make them low-risk. However, one major drawback with fixed deposits is that the returns often fail to beat inflation. In fact, this is a major challenge with most fixed-income investment options.
For instance, let’s assume a 35-year-old investor who falls under the 30% tax bracket invests Rs. 1 lakh in an FD for 1 year that gives 8% returns. Let’s also assume that the inflation rate during that year is 4%. As a result, the 8% returns (translating to Rs. 8,000, total fund value becoming Rs 1,08,000) is in reality a 4% return when you factor in inflation. Plus, a 30% income tax need to be paid on the Rs. 8,000 returns (which is equal to Rs.2,400). So, the actual return (inflation-and-tax-adjusted) should be only Rs. 1,600, and not Rs. 8,000, something that might not be enough to meet the investor’s financial goal. That being said, senior citizen depositors get a tax exemption of up to Rs.50,000 on FD returns. Plus, the FD interest rates are generally higher for them.
Kisan Vikas Patra (KVP): Let us take KVPs as another example. This is a type of small savings scheme that is made available through the India Post. It promises to double the investment amount after 113 months. The current rate of interest on KVPs is 7.6%. However, the catch is that neither can it offer tax benefits for a person in the 30% bracket nor can it particularly beat inflation. So, tax and inflation will have a major bearing on your returns after 113 months.
Endowment plans: Generally, traditional endowment plans that come with a money-back policy give tend to be a ‘hot favourite’ investment-cum-insurance option. However, the reality is that the real returns that are offered on these plans tend to be, in some cases, lower than that offered on FDs.
Equity: If beating inflation is your ultimate goal and you are looking at long-term wealth creation, you might also consider equity investments apart from low-risk fixed income instruments. Most people tend to be sceptical about making investments in equity due to lack of awareness or familiarity. Equity is not just about buying shares, it could also mean just investing in an equity-based mutual fund.
In simple terms, what inflation can do is give you back lesser than what you actually put in. And that is a counter-productive proposition because the main purpose of investment is wealth creation.
So, what can an investor do?
- Always invest according to your financial goals and risk profile: Direction-less investing often leads to confusion. So, it’s important to invest according to your financial goals with pre-defined time targets (like raising Rs. 1 lakh in a year for a year-end trip, Rs. 15 lakh in 3 years to build a house down payment fund, and Rs. 3 crore after 25 years to build retirement corpus). The second thing to consider is how much risk you can take on your investments. While younger investors with fewer commitments can take higher risk, people nearing their retirement age cannot risk their retirement corpus and hence, will have a lower risk appetite.
- Have a diversified portfolio: The good old saying of not putting all eggs in one basket holds true. It is always better to have a good mix of investments in your investment portfolio which are in line with the returns requirements of your financial goals and your risk profile in order to keep the combined risk under control.
- Look for inflation-beating investments: Add equity investments, preferably a staggered one like Systematic Investments Plans (SIP), in your portfolio to absorb the shocks of inflation and income tax on your investment returns. You should also consider investing in tax-saving Equity Linked Savings Schemes (ELSS) if you haven’t maximised the 80C deduction limit of Rs. 1.5 lakh. Do note that ELSS investments come with a minimum 3-year lock-in period.
- Rework your allocation: An investor should review his portfolio periodically and make necessary changes related to fund allocation if need be. Also, due diligence in terms of investment instrument selection is a must. Consult a financial advisor if needed, but don’t make investments decisions based on mere assumptions or hearsay.
In conclusion, factoring in the impact of inflation and tax on your investment returns are keys to an informed investment strategy. So, always consider the real rate on your investment returns to meet your financial goals in time.
The author is CEO, Bankbazaar.com