Inflation is a very commonly heard word and assumed to be understood well. However, not everyone factors that understanding into financial decision making, thereby overestimating returns or under estimating objectives. We further compound the effect of inflation when we fail to calibrate our lifestyle according to our affordability.
What is Monetary Inflation?
In simple words it is the increase in prices of goods and services over time. It implies reduction in purchasing power of money, i.e. reducing its value over time. For eg if you can buy some item for Rs 100/- today- it might cost you Rs 105/-after one year. The Rs 100/- currency will not be having the same purchasing value after one year.
Effect on Investments
We generally consider the annualized returns from our investment and are comfortable with the absolute growth. But the actual growth can be measured only by the increase in purchasing power. This will be possible after reducing, or discounting the inflation effect from the annualized returns. For eg If I get 7.1% in the Provident Fund when the inflation is at 5%, the actual growth in value is of approximately 2% only. In the prevailing scenario, the risk free returns are continuously getting lower. And at some point of time these may even fall below the inflation rate. At this stage, taking no risk will probably be more hazardous than taking some risk.
What can we do about Inflation?
Inflation is a fall out of complex economic matrix influenced by several factors. RBI attempts to manage it within a legislated band through its monetary policies, but we cannot do anything about it. What we can surely do, is to ensure that the value of the money that we have does not degenerate. We can do this by putting it into those instruments which give at least inflation beating returns. Further you should be able to calculate your future requirements factoring the growth potential of your investment as well as future cost of the financial objective. One needs to stay abreast with the long-term inflation trends related to your financial objectives like real estate, education, travel, commodities etc. A simple example of two scenarios is as under:-
(a) You have Rs 100/- today and plan to buy what you want after one year. In this case you need to appreciate that after one year the same thing will cost about Rs 105/-. And therefore ensure that the presently available Rs 100/- grows to at least 105/- after one year.
(b) You have only Rs 50/- today and plan to have enough money after one year to buy something costing Rs 100/- today. In this case you have to plan to save/grow the present Rs 50/- to Rs 105/- by the end of the year to buy the same thing.
What is Lifestyle Inflation ?
This is something which we bring to bear on us on account of our own doing. When there is an increase in income, say Increment/DA, we tend to upgrade our lifestyle in either same or higher proportion. This invariably absorbs the entire increase in income. We fail to recognize that most of the increments in DA/Pay are there to cater for increased costs of living i.e. monetary inflation. They at best suggest a modest lifestyle increment in measured proportion. The problem is borne more of psychological reasons and self-imposed social/peer pressures. One major problem with Lifestyle inflation is that once increased- it is extremely difficult to voluntarily reverse it. When forced to reverse due to circumstances- it is extremely distressing and painful.
What can we do about Lifestyle Inflation?
This is something which is totally in our control. We need to ensure that we live a lifestyle which can be sustained during our entire lifetime with our accumulated means/assured income. The improvement in lifestyle should be in tune with our growth in net worth, and monetary inflation. As everybody’s net worth is dependent on their incomes/ inheritance/ savings/ investments; it would be different for different people, so should be the lifestyles. Even if for the moment we are in the same profession, we carry a very diverse set of assets and liabilities, and therefore the objectives (and paths to these objectives) will be different.
Conclusion
The situation however is not always negative. At times, a detailed review may indicate that you have the capability to live a better quality of life. But overcautiously you may have been living miserly. As a benchmark, always ensure that at least 30 % of your income at any given time is deployed towards savings/investments. This ratio needs to be higher if there is significant gap between existing net worth/savings and the future financial objectives.