What is inflation?
Inflation can be understood as the sustained increase in the price of goods and services over time. As inflation increases, your purchasing power decreases, meaning each rupee you own would buy lesser goods or services than it did ten years ago due to positive inflation.
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Inflation and Interest Rate
The interest rate mentioned on any investment product is the nominal interest rate. Taking an approximation of the formula:
Nominal Interest Rate = Real Interest Rate + Inflation
Thus, an interest rate of 8% on your fixed deposit really gives you interest at 4% (taking inflation rate to be 4%).
Let’s take an example to understand this better. You have 10,000 rupees that you put in a fixed deposit at a rate of 8% per annum for a year. After a year, you receive 10,800 rupees. However, during this period, inflation grew at 10% per annum, which means your actual return is negative! Why? Because if a bottle of water was priced at 10 rupees when you invested the money, it is now priced at 11 rupees. You could have bought 1000 bottles of water with 10,000 rupees then, but now you need 11,000 rupees buy 1000 bottles of water (you only received 10,800 rupees when your FD matured).
This example shows how inflation can bring down the effective value of your returns. So where should one invest to be relatively safe from the effect of inflation?
Understanding the risk of inflation is key to smart investment. Keeping your money in a locker would also lower its value over time. You’d rather opt for one of the following:
Gold and Silver – Though gold and silver tend to retain their purchasing power over time, this may not always be the case. Investing in gold doesn’t provide you any real income but only a source to rely on in the future.
Bank Deposits – Considering the continuously lowering interest rates and inflation crossing 5%, investing in fixed deposits is like filling a trickling bucket. All it may do is keep the value of your money intact (if inflation doesn’t hit the roof) but not offer any real returns.
Equity – Investing in equity or mutual funds over a long period of time can be a good strategy for fighting inflation. A diversified portfolio can spread your risk and offer consistent returns if you stay invested for a long term.
- Finding stocks that pay dividends is a good idea as dividends coupled with capital gains can effectively fight the effect of inflation on your investments.
- Fixed income funds such as corporate bonds and senior secured loans yield more than inflation in the long run and offer much better interest rates.
- Buy some utility stocks. The demand for water, gas, electricity etc. would always grow despite the upward or downward market trends. Though mutual funds investing in utilities rise and fall in tandem with the economy, the dividends make them an ideal choice for investment.
Worried about the long term value of your savings? Let Nave Marg guide you towards a secure and prosperous future by helping you invest right.