Before going on with the topic, i would like to take some time and say a "big thanks" to all readers/subscribers of "Investment School" on the occasion of the 50th post of my blog. I am encouraged by your astounding response to my blog and consistent tracking of my blog. Its your active reading that makes me to write more on investment and best practises. Thanks again!

What is inflation?

To put it in simple terms, inflation is nothing but an increase in cost of living for a person on a yearly basis.

Eg. If inflation is 8%, then theortically a good which was sold for 100 rs an year back is now costing Rs 108. So inflation is not a very tricky and difficult to understand , it is as simple as the above example.

How does inflation affects investments?

Inflation reduces the purchasing power of money. 100 rupees can purchase you more last year than what it can purchase as per the last example.

Inflation also erodes investment. Lets see this with an example.

Eg. Ram invests Rs.1,00,000 in a bank FD fetching him 11% interest rate on yearly basis. Ram is in a income tax bracket of 20%.At the end of one year, he gets back Rs.1,11,000 and he pays 20% of 11,000 as tax.

Amount Invested = 1,00,000

Maturity Amount = 1,11,000

Interest Earned = 11,000

Tax on Interest @ 20% = 2,200

Amount in Hand = 1,08,800

Interest Earned = (8,800/1,00,000) * 100

= 8.8%

If the inflation prevailing is 7%, then

Real rate of return/Inflation adjusted return = 8.8% - 7%

= 1.8%

This implies value of money at your hand has increased only by 1.8% and not by 11% or 8.8%.

As we can see in the above example, inflation erodes the return from our investments significantly.

How to reduce the impact of inflation?

We should choose a mix of investment instruments, so that the collective return out of our investment should beat inflation by a good margin of (8-10%) so that real value of our money increases in a significant manner.

Lets rework the same example above by splitting across two investment instruments - debt and equity invested for 12 months or 1 year.

Amount to be invested = 1,00,000

Amount invested in equity = 50,000

Amount invested in debt = 50,000

Interest earned in debt = 11% (0r) 5,500

Tax on interest = 20% (or) 1100

Interest - tax = 4,400

Interest earned in equity = 20% (or) 10,000

Total Interest Earned = 14,400 (or) 14.4%

Inflation = 7%

Real rate of return = 14.4% - 7% = 7.4%

So the inflation adjusted return has increased from 1.8% to 7.4% by reallocating the amount in two different modes of investment. The returns mentioned are assumptions, you need to reallocate the %age of amount in each asset class based on interest available during your investment period.

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