Do not miss on factoring inflation while estimating the monthly savings required to meet a long term goal.
Inflation plays an important role in the process of investing, especially over the long term. As an equity mutual fund investor, one may choose to invest through SIP towards a specific goal such as child education. But, if the amount of monthly savings does not take into account the impact of inflation, there is a likelihood that the investor will fall short of the required funds at the time of need.
Using a SIP calculator, you might have calculated the maturity value but ignored the impact of inflation. You may end up not saving the right amount as the purchasing power of money keeps coming down because of inflation. The cost of the goal in later years will be much more than it is at today’s cost. Education that costs Rs 15 lakh at today’s cost, may cost you Rs 40 lakh after 20 years!.
This is due to education inflation which can be safely assumed to be increasing at around 5 per cent annually. So, instead of Rs 1500 of monthly SIP, assuming growth of 12 per cent, you should be having a monthly SIP of Rs 4000 to meet the cost of higher studies of your child and avoid any shortfall. In other words, the worth of Rs 15 lakh after 20 years will be just about Rs 5.65 lakh. Do not miss on factoring inflation while estimating the monthly savings required to meet a long term goal. Rajesh Cheruvu, CIO, Validus Wealth in an email interview shares the reasons and the way forward for investors to mitigate the impact of inflation on the investments.
When the investor starts SIP without estimating the inflation-adjusted amount of the goal, can we say it is the wrong way?
What is wrong and what is right can only be said in hindsight, once the outcomes have played out. There is always an element of chance in decisions – rarely are they risk-free. One risk from investment decisions is inflation risk, which is the risk of eroding the purchasing power of a corpus of money.
Using representative numbers, if a bag of goods was costing Rs. 80/kg a year ago, the same Rs. 80 would now be able to buy about 830 grams only because prices may have gone up 20 per cent. So one should invest the Rs. 80 into an asset that generated at least 20 per cent returns in order for him to purchase the same weight of the good now, as he did a year ago.
So in a SIP as well, since an investor puts in a fixed amount of money at every interval and it happens that inflation is also increasing rapidly in that interval, then it implies that he would most likely under-achieve his target as the real money (i.e. stripping out inflationary gains) invested is decreasing every interval.
How does inflation play a role in one’s investing process through SIPs?
Inflation eats into the purchasing power of money. So if an investor invests Rs. 100 as SIP every month and if inflation increases 3 per cent in the month, then the worth of his SIP in the second month is only Rs. 97.
The flip-side view is that his corresponding expenses, investment goals and targets have all shot up by 3 per cent. So same side of the coin can be read as either: inflow Rs. 100; expenses up by 3 per cent or inflow Rs. 97; expenses staying put. So one would need to keep an eye out for any sharp inflation upticks or budget for the expenses to include an inflationary push over and above the real requirements.
What should be the approach while starting to save for a long term goal?
For the long term goal, the real value of the cash outflow needs to be estimated and that an expected inflation rate added, to get the nominal expected goal. Once this is set, one needs to map out own risk profile. Then a strategic asset allocation needs to be set in place which would match the risk preferences and at the same time generate a return sufficient to meet the nominal expectation.
Tactical asset tweaking can be done periodically to capitalize on any favourable asset class views one might develop in the course of the investment tenure. The routes to market for taking exposure in the assets are aplenty and depend on the asset in question. If the asset is equity, then SIPs are one way of averaging market volatility, especially in falling markets as the same quantum buys more units of exposure.
However, abnormally high periods of short term inflation spikes could erode wealth. Overall, adherence to strategic asset allocation with opportunistic tactical shifts are the cornerstones of the investment discipline.