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Inflation eats your money, fight it out!

by Money Puzzle   ·  January 17, 2020   ·  

Inflation eats your money, fight it out!

by Money Puzzle   ·  January 17, 2020   ·  

Headlines in newspapers, news channels and social media this week have focused on how in December 2019 inflation was at 7.35%. Well, who cares? Does it really matter in our daily lives what the inflation number is?

Not only does inflation impact our daily lives but it also impacts our wealth in the long run. The earlier in life you understand this concept of inflation the better you will be able to grow your returns and create wealth.

What is inflation?

In simple terms, inflation is the price rise of a specific basket of stuff defined as important in every citizen’s daily life. Typically, this basket will contain things like food, fuel, housing and so on. The current basket as defined for Indian inflation consists of food items, fuel and power, housing, clothing, pan and tobacco and miscellaneous items including transportation, recreation, education etc. These items are not put into the basket in equal proportion, rather food takes up the largest space at nearly 46%, followed by housing at 10.07% and transportation and communication at nearly 9%. This means that almost half the basket is full of food.

What does this 7.35% December inflation number mean? It means that the aggregate price of purchasing this basket full of different things has gone up by 7.35% or ₹7.35 per ₹100 in December 2019 when compared to its price in December 2018.

Why has this happened? If you look at the detail, it’s primarily thanks to the prices of vegetables – which have shot up 60% in one year, prices of proteins like egg, meat and fish – which have increased by 8.5%-9.5% over the last year, and even your dal prices have increased roughly 15% over a year and lastly, personal care product prices which are up by 6.8%.

Here is why it matters – firstly, these are things that you use daily and are unlikely to stop buying even when prices rise – because you need it. Do you know that a month ago, In December 2019, onion was selling at 120-140 a kg? Did homes and restaurants stop using onions? Unlikely.

What happens is that expenditure goes up.

Secondly, the overall inflation rate will proportionately reduce the purchasing power of your rupee. See, the stuff in the consumer basket, which I highlighted earlier, does not change. Now, last December you could buy this stuff for 100 and in December 2019 it costs 107.35. The purchasing power of your rupee has declined by 7.35% or in other words 100 is now worth 93.15!

Inflation makes the value of money FALL!

Take a pause now and watch this brief video

Investments meant to beat inflation

As explained in the video your investment return really needs to be above the rate of inflation for you not to lose money. You may earn 7% every year on your fixed deposit, but post-tax that can fall to 4.8% to 6.2% depending on your income tax bracket. Now 7.35% inflation, remember the value of your ₹100 in the bank FD has fallen to ₹93.15; even with a 6.2% post-tax return at the end of the year your ₹100 is worth only ₹98.95 in real terms.

Which means, that the ₹100 from last year despite being invested in a fixed deposit – can only buy stuff worth ₹98.95 – you are losing money!

The way out is to invest in what we call growth assets. This includes assets like equity and real estate which compound in value over a period of time. If you are investing for more than 5-7 years or in other words, you don’t need the money for at least 5-7 years, then it’s better to choose growth assets.

Investing in equity is more flexible, transparent and easy to do as compared to real estate – but that’s a choice that will depend on many other factors. Historically, 10-15 year return from equity assets (proxy equity mutual funds) has ranged between 15%-17% – however, in periods of low inflation, this has fallen to 12%-13%. Moreover, the choice of fund manager also matters.

Anyway, this article is not a lesson in investing, for that you can go HERE.

By choosing growth assets, you are making your money work hard in over a long period of time and at an assumption of 12% annualised return over 5-7 years or longer, your real return will be positive and growing.

Make the right choice

For accumulating wealth, it is important to start investing early, but it is also important to make the right investment choice. Choosing fixed return products like fixed deposits will not help you beat inflation, hence, you will not create wealth. For wealth creation, you need to add equity assets to your portfolio. This is the only way to beat inflation – over which you have no control – and create wealth (this is in your control).

The next time you see an inflation number flashing somewhere – remember not only does it matter in your daily life, as things become more expensive, it also eats away at your money. It’s up to you to make the smart choice and pick long term investments which can beat this inflation and help your wealth creation.

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