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Impact of Inflation

Recently i received a call from one of my friend working in Pharmaceutical sector, he called me to inform that he got 6% salary hike & was quite delighted with this hike…After phone call i was wondering whether he really got a Salary Hike & the answer is big NO…You must be wondering, Why?

Let me answer this but before answering let me ask 1 question..What is Inflation? 99% of people will answer that it’s a parameter or gauge to measure the rise in price of essential goods & services..Fair enough and it’s right also…I searched internet and got same definition almost every time…

But there is a dark side to inflation, which no one tells becoz truth is always bitter

Inflation eats into your saving & devalues the currency

Next question is how? Let’s understand

Assume u had deposited 100 Rs in your Savings A/C one year back and you received 4% interest for same..After 1 year, u have 104 Rs in your savings account and you are happy…Now in current scenario, Average Inflation is 7% therefore the real value of your 100 Rs is reduced to 93 Rs in 1 year, Real Value is also called purchasing power of money…What it means is that 1 year back if u  would have needed 100 Rs to buy particular set of goods then today you need 107 Rs to buy the same set of goods therefore you need more money compared to 1 year back, which implies currency is devalued or purchasing power of 100 Rs is reduced to 93 Rs….

Now due to impact of inflation, purchasing power of your 100 Rs which u saved 1 year back is 93 Rs and you received 4 Rs interest therefore in terms of purchasing power your 100 Rs has become 97% despite 4% interest you received…Therefore your savings have actually depreciated…In a nutshell, inflation has eaten into your saving and has devalued currency by reducing its purchasing power that is why Inflation is Bad.

What is Real Return? Real Returns are returns after adjusting inflation therefore if u received salary hike of 6% and inflation is 8% during the year then your real return or hike is -2% or if u received return of 8% through FD with 8% inflation then you can pat our back that despite inflation you managed to retain the purchasing power of investments or savings.

Real Returns or we can say, in actual terms your investment is appreciating only if u beat Inflation by generating returns greater than inflation..Going by this criterion definitely your investment is de-growing if your investment is lying idle in Savings A/C.  Investments remained stagnant or not growing if you have FD’s with return of around 8% p.a which means u just managed to beat inflation but all smart investors always target Real Returns.

Next big question, how to generate Risk free Real Returns…Answer is, you cannot generate real returns without taking risk…You have to take calculated or minimum risk to beat inflation and generate inflation adjusted returns or Real Returns. Answer is my personal favorite Gold ETF’s. Over centuries, Gold is considered as best bet to hedge your investments against inflation. Over a period of time, only GOLD is able to generate Real Returns for investments…Though many people will suggest investment in equity but it’s a big NO under any circumstance as equity investment is as good as gambling rather generating inflation adjusted returns…Ideal allocation at young age is 75% in safe instruments like FD’s and 25% in Gold so that u can get atleast 4-5% real returns p.a. but it all depends on your risk appetite…How it work, let’s see

Assume, you have 100 Rs and u invested 75 Rs in FD and 25 Rs in Gold…After 1 year your 75 Rs will become 81 Rs and assuming Gold will give return of 25%, your 25 Rs in Gold will become 31.25 Rs..Therefore your 100 Rs is now 81 Rs + 31.25 Rs = 112.25 Rs..Assuming inflation is 8%…Your Actual Return is 12.25% and Real Return is 4.25%…Real Return of 4.25% is very good as it is post adjusting inflation…Higher the inflation, better will be return on Gold…Sometimes there might be slight downward movements in gold for short duration but in long run, Gold has never ditched its investors.

Also one Golden Advice, Don’t go by your investment banker as their motive is not to generate returns for you but for themselves & banks for which they work…Its better to generate 4-5% Real Return rather living under fear of losing money as 5% Real Return is actually 13-14% absolute return.

Copyright © 2011-2012 Nitin Bhatia. All Rights Reserved.

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