Accounting for Inflation while Investing

Inflation simply means an increase in price, and therefore a decrease in the purchasing power of your money. Because of inflation, Rs. 100 in your wallet today will be able to buy fewer goods next year than they can buy today. Inflation is calculated and published on an annual basis, so an inflation rate of 6% means that in one year, the price of goods and services rose 6%. In other words, you would have to pay Rs. 106 for goods that you could buy for Rs. 100 a year before.

The connection between inflation and interest rates
When investing your hard-earned savings, you must account for inflation and seek an inflation-adjusted rate of return. Going with the previous example, if you invested your Rs. 100 at 8% return, then your inflation-adjusted or the real rate of return would be 2% (8% minus 6% inflation).

Interest rates are also linked to inflation. Savers naturally want to earn interest rates higher than inflation. At the same time, borrowers want interest rates to be low. The Reserve Bank of India does a balancing act between inflation and interest rates so that savers can earn real returns but borrowers don’t find loans too expensive.

Tracking Indian inflation trends

As this chart shows, inflation in India has stayed in the 4-6% range in the last few years. It is the stated stance of the RBI to keep inflation rate below the 5% mark so that interest rates remain low, which would enable more and more people and companies to take loans to purchase assets or run businesses and help the economy. However, keeping interest rates low also means that popular investment choices like bank deposits and government bonds will yield lower returns.

Tracking Indian interest rate trends

The average rate of return on fixed deposits (FDs) among the major banks has remained between 5%-6% in the last few years, which means that an investment in fixed deposits will yield very low real rates of return. Besides, taxes on interest earnings can make the actual returns even lower for investors. So while FDs are a safe investment, an investor seeking higher returns may have to look beyond.  

The rise of mutual funds in India
Mutual funds have emerged as an effective solution to optimise financial planning and financial wellness and have gained in popularity over time. Critically, mutual funds earn market-linked returns, and are thus able to potentially stay ahead of inflation over the long term much more than traditional fixed deposits.

There are significant advantages to mutual funds that explain their growing popularity:

●     They are managed by highly experienced investment managers with track records in various asset classes

●     Economies of scale lead to a reduction of expenses, and give the investor a choice of different types of mutual funds

●     They are highly regulated by the Securities and Exchange Board of India (SEBI)

●     Some schemes are eligible for tax benefits (under Section 80C of the Income Tax Act of 1961)

●     They can be easily redeemed

●     They tend to be cost-effective, accessible investments (and you can start gradually, buying mutual funds through SIPs)

Ultimately, every investor is different, with unique risk appetite and preference of asset classes. To know the right avenue for you, consult a financial advisor and begin your investment journey today!

Source:
https://tradingeconomics.com/india/interest-rate
https://www.macrotrends.net/countries/IND/india/inflation-rate-cpi
https://www.amfiindia.com/investor-corner/knowledge-center/history-of-MF-india.html#accordion5