Simply put, inflation refers to the rising cost of living due to an increase in price levels. This reduces your purchasing power and, as a result, you are able to buy less with the same amount of money compared to what you would have bought a decade or two ago. The value of your savings also goes down and you may not be able to achieve your financial goals. Let us understand this with an example:
Rahul wishes to send his son abroad for education when he turns 21, which is 15 years from now. He estimates the current cost of foreign education (including all ancillary expenses) at R12 lakh. Now, assuming that the cost of this education will increase by 8% every year (this is the inflation), the total cost at the end of 15 years will be a little over R38 lakh. Thus, Rahul should plan to save R38 lakh for his sons foreign education and not R10 lakh.
This is true for each of your financial goals be it retirement, childrens education, their marriage, vacation or medical expenses. Inflation can, thus, create havoc in your financial life if not dealt with properly.
What is the best way to deal with inflation when you plan your finances and goals The obvious answer would be to choose investments that help you counter inflation in the form of higher returns. Lets have a brief look at a few such investment options:
Equity: Equities generally give the best returns over the long term, thus helping to effectively combat long-term inflation. You can invest in equities either directly through stocks, or take the mutual fund route. An experienced investor who understands the markets well and has the time and knowledge to deal with the volatilities can look at direct investing in stocks. This can give you higher returns, but also comes with higher risk.
On the other hand, a more conservative investor can choose to participate in equities indirectly, by investing through the mutual fund route. This lowers risk, but also gives you lower returns than direct investing. It is better to choose good funds that are diversified and have a strong history. Thus, equity investments are a good way to counter inflationary trends. However, remember that equities are not the best of options for the short term due to the increasing volatility which is seen in the stock markets.
Real estate: This is yet another asset class that deliver returns in line with inflation. When inflation is high, property prices also tend to go up, giving you good returns. You can also let out your property and earn rental income, which will also be in line with inflation.
However, not everyone can invest in real estate due to the high property prices and legal formalities. It should nevertheless be considered as one of the investments in your portfolio to help you gain from both capital appreciation as well as earn rental income. Remember to choose a reputed builder with a good track record. Also consider all hidden costs, location aspects, potential for the area to develop and other legal aspects before investing in property.
Inflation-indexed bonds (IIB): These are debt instruments that deliver returns in line with the inflationary trends. That is, the principal amount of the bond is adjusted to reflect inflation in the economy. While these are good in inflationary situations by helping you earn higher interest, they may not work to your advantage in deflationary scenarios. Therefore, you must invest in them only if you expect a high inflation scenario.
Gold: Investing in gold acts as an effective long-term hedge against inflation. Equity and gold generally move in opposite directions, helping you balance your returns.
While the best way to deal with inflation would be to invest in instruments that help you counter inflation, you must also pay attention to your asset allocation profile, depending on your age, risk appetite, asset and liability pattern and financial goals.
The writer is CEO, BankBazaar.com