Effect of inflation on investments

When you notice that it is inflation that is reducing your purchasing power, then this is the question that would also arise on your mind. How will inflation affect my investment portfolio? The effects of inflation definitely cannot be under-valued but there are quite a lot of other considerations that can impact your earnings than mere inflation.

Let us have a look at the stock market: If the majority of your investments are in the form of shares and securities, a rising inflation need not give you months of sleepless nights. The reason behind this is simple. The companies’ earnings and profits will also rise at the same pace or even faster than inflation.

For example, the value of a stock belonging to XYZ Company is Rs 500 per share. Three months later the value of the same share is Rs 800. You get flat 40% hike on your investment value altogether. So rising prices of commodities need not strike your nerve on what will happen to the investment. This is if you have invested most part of your money into shares, securities or derivatives.

But if the economy is continuously performing on a sluggish note and despite the gloomy scenario, prices of goods and services keep rising resulting in growing inflation, then there is something concrete to really worry about.

Company’s books of accounts are overstated while inflation is the real thief: Let us have a look at the impact of inflation from a slightly different angle. With growing inflation, stocks of companies tend to remain overstated.

Suppose a company offers you a return on investment to the tune of 10% per annum. In other words, the investment value is Rs 1,000 and by the end of the year, you are offered a sum of Rs 1,100. Do you think this Rs 100 is the tangible value of your investment? No, definitely it is not. The company’s real returns are not 10%.

Growing inflation, as it is already discussed, reduces the purchasing power of real-time tangible goods.

If the rate of inflation for that particular year stood at 4%, then your real rate of return or rather the tangible rate of returns is calculated as 10% minus 4% which is 6%. In short, you have only received 6% from the company as the tangible rate of returns on your investment.

The real-time tangible rate of return is the actual value of your investment portfolio. However, most of the investors fail to understand this underlying concept. Most of the investors simply get carried away by the nominal rate of returns a company offers on their investment. They forget about the inflation factor altogether.

Henceforth, when a company offers a fabulous rate of returns on investment, it might apparently look as if the company is moving on a progressing note. But it is inflation that lies behind the growth. Growing inflation can also prove havoc to the returns or earnings a company offers its investors, overall. However, if companies use clever techniques to value inventory, investors can be spared of their dear investment.

Inflation investment bonds: To help investors safeguard their capital money and to help investors get rates of return in such a way that they are not wiped out by growing inflation, Indian mutual fund companies offer investments with inflation protection schemes.

In other words, no matter how inflation strikes the economy hard, you are assured of getting your principal money back along with the stipulated rates of return, the company has initially offered you.

Inflation-indexed securities are more appealing for the fixed income group comprising of pensioners, senior citizens, and retirees. The rate of returns might be a little nominal, but you are assured of getting ample protection for your funds against inflation. In other words, the effects of inflation are made marginal, in this case.

If you want to get yourself protected from the evil consequences of inflation, it is better you start your savings in your early 20s.

You start saving money every single month and the interest rate gets compounded and early savings help you build your investment portfolio in a big way. By the time, you are in your early 30s you need a substantial sum of money to have your wedding done or to build your dream home.

As what is Rs 40 lakh today reduces to Rs 25 lakh, 10 years down the line. In other words, the purchasing power of goods and services for Rs 40 lakh today can fetch you the same quantum of products and services worth Rs 25 lakh, 10 years down the line. You must, therefore, be aware of the consequences of inflation. Knowing the impact of inflation is important for financial planning.

( The writer is the Chief Executive Officer of Broking & Distribution at Motilal Oswal Financial Services Ltd)