Starting to save through mutual funds SIP without considering the impact of inflation could leave you with a huge shortfall in the long run.
Merely starting SIP may not be sufficient unless you save the right amount to reach your goal.
Who doesn’t want to get Rs 1 crore or even a higher amount of, say, Rs 2 crore by investing in different investment products? To become a crorepati or multi-millionaire, with limited funds, either the holding period has to be long or the growth rate has to be high. Generating high returns comes with big risks and, therefore, one should try to invest in investments that are well-regulated and where risks are manageable.
But, another risk that often gets ignored is the inflation risk. Inflation eats into the purchasing power of money and hence the actual worth of Rs 1 crore or any amount at a later date will be less than what it is today.
Let us assume, you want to save Rs 1 crore after 20 years but by the time you actually have accumulated Rs 1 crore, it’s worth could be only Rs 25 lakh! Yes, assuming the average inflation during the next 20 years to be at 7 per cent, you will fall short of becoming a crorepati by almost Rs 75 lakh.
Starting to save through mutual funds SIP without considering the impact of inflation could leave you with a huge shortfall in the long run. If you are aiming to achieve a long term goal by investing in SIPs, the cost of the goal could have increased exponentially by the time you near them. This is because of inflation and just like tax eats into the returns, inflation eats into the purchasing power.
When you start saving through equity mutual funds, it should be for meeting your long term goals. The investing process should, however, be a planned and a systematic one. An ad-hoc saving approach with no proper planning may end up in a short-fall in meeting your goal. Investing in equity MF can be done through SIP which brings in financial discipline to your savings process. However, merely starting SIP may not be sufficient unless you save the right amount to reach your goal.
Inflation impact on investment – Example
Let us say, after 20 years you want to send your child for higher education which costs Rs 20 lakh today. To save Rs 20 lakh after 20 years, assuming a return of 12 per cent, you need monthly SIP of Rs 2500 to save.
If the assumptions remain true, you will have Rs 20 lakh after 20 years but you have ignored the impact of inflation. The cost of education is rising and education inflation is considered to be around 10 per cent.
The impact of inflation is such that it decreases the purchasing power of rupee. Using the purchasing power of money calculator, one may find out that the purchasing power of Rs 20 lakh after 20 years, at an assumed 7 per cent, will be about Rs 5 lakh. As costs are going up, the worth of Rs 20 lakh is reduced to Rs 5 lakh!
Therefore, before starting to save for your long term goal, make sure you have estimated the inflated cost and then do SIP.
In the above example, Rs 20 lakh after 20 years at an assumed 7 per cent inflation will actually cost you Rs 77 lakh. Now, to save towards it, you actually need to do SIP of Rs 7500 instead of Rs 2500.
Similarly, if you wish to save Rs 1 crore, Rs 2 crore or Rs 5 crore, you find out the monthly SIP amount using a SIP calculator and start saving towards it. However, on maturity, the worth of Rs 1 crore will be much less because of the inflationary impact.
Also, while using a retirement calculator, it is equally important to adjust household expenses for inflation. Currently, if your monthly household expense is Rs 35,000, after 20 years, assuming an inflation of 5 per cent, it will be about Rs 92,000.
Inflation calculation formula
In an excel sheet, you can use the following formula to calculate reduced value because of inflation:
Reduced amount = amount/(1 + inflation rate)^number years
For example, worth of Rs 1 crore after 20 years at an assumed inflation rate of 5 per cent will be –
= 10000000 / (1+5%)^20
= Rs 37 lakh ( approximately)
Therefore, before you start SIP, identify your long term goals such as children’s education or marriage and your own retirement. This will help you to link MF investments to specific goals. Then, find out two things – Today’s cost of the goal and Years left to goal. Finally, calculate the inflated cost and monthly savings required to achieve it using the SIP calculator.