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Monday, 9 January 2017

How does inflation affect your investment?

Money Saved is money earned. This is an old saying. But thanks to inflation the real value i.e. purchasing power of that saved money would dropped day by day. We can't afford to ignore the corrosive effect rising prices or inflation can have on the value of our savings. In just 20 years, 4% inflation annually would drive the value of a 100 Rs. down to 44 RS. It means if you saved 100 Rs. to buy any good and you waited with your saving then you can’t afford it after some time. Thus, any benefit gained from higher saving and investment (due to increased inflation) is virtually erased by the reduced purchasing power..

Inflation works against our investments. When you calculate the return on an investment, you'll need to consider not just the interest rate you receive but also the real rate of return, which is determined by figuring in the effects of inflation. We as an investor should be concerned about the real return on our investment as inflation typically reduces the purchasing power of any currency. We need to understand the relationship between nominal interest rate, real interest rate and inflation.

Real interest rate = Nominal interest rate - Inflation

The interest rate quoted on any particular investment is generally the "nominal interest rate". Hence, the interest rate quoted on your fixed deposit of 8% is the nominal interest rate. And inflation is 10% then real rate is -2% means our 100rs can have value to 98rs after a year.

Clearly, if you plan to achieve long-term financial goals, such as college savings for your children or your own retirement, you'll need to create a portfolio of investments that will provide sufficient returns after factoring in the rate of inflation. An investor should ideally look at options that either generate positive real return for him or at least provide some natural hedge against inflation.

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