Investment is important as it helps grow your money in due course of time and create wealth. Investments are meant to generate returns on your principle sum. It is a general practice among individuals to focus on what returns they are likely to get in absolute term. This could prove to be an unhealthy thought process which leads to bad investment experience.
Why Is This So?
Returns from any investment should always be seen in relative terms to your rising cost of living. In short, you should take inflation into consideration before calculating the actual rate of return you are likely to get on your investments. This is what known as inflation-adjusted return.
For instance, you invest Rs. 100 for a year, say in a bank Fixed Deposit with a rate of interest of 7%. After a year, your principle sum turns into Rs. 107 and you are content with the fact that your money has grown over the last one year by 7%. Now, assuming, rate of inflation to be at 5%, something which cost Rs 100 a year ago is now costing Rs 105. If you take inflation of 5% against your return of 7%, the effective rate of return you are making on your investment is merely 2% (7-5). Now, think again whether you are content with 2% return.
The rate of inflation in recent years has been under 5%. However, some years in the past have seen much higher inflation as high as 9%. Going further back, we’ve also had inflation in the double digits. In such scenarios, your effective rate of returns from instruments offering you 7% as the rate of interest dives into negative territory (7-9 = -2%). Many don’t believe this, but it’s true: your principle amount sees erosion in value and your investments are more or less look like savings in a piggy bank wherein value of your money deteriorates every passing day.
What’s The Alternative?
It is advisable to look for financial instruments which are capable of offering you inflation-beating returns. Upon failing to do so, you run the risk of not only wealth erosion but you deprive yourself from attaining your financial goals which will lead to financial stress. Inflation is a financial menace which could prove disastrous if we don’t realise the potential damage it can do to your financial health.
You should not be attracted by high rate of returns. Instead, ask yourself whether it is good enough to beat inflation going forward from a long-term perspective. If your answer is ’No’, you must avoid going for that financial product and search for alternatives for better yield on your investment. Ideally, you should opt for investment avenues which can offer you at least 4-5% more returns over and above the rate of inflation in the long-term. You should also discern between short-term and long-term instruments. You still need the humble fixed deposit with its 7% returns to keep your money safe for the short term. However, to build wealth for the long-term, you need other instruments.
In summary, don’t be satisfied with absolute return. It is quite misleading and could destroy your financial health beyond repairs. Time has come to change your thought process when it comes to investment. You need to be a smart investor and adopt to best investment practices as per the fast changing times.
The writer is CEO, BankBazaar.