Effect of Inflation & 4 Best Investments to Earn Inflation Beating Returns

Whenever I ask my parents out for a movie, there’s this one thing I always hear from them. Effect of Inflation Very true. Back in the 1990s, a movie ticket would barely cost you Rs 30. While today you need to pay Rs 500 to Rs 700 or sometimes even Rs 1,000 per ticket. That is an insane rise in prices. But have you ever wondered what makes the prices of goods and services rise? Well, this is the effect of inflation. In this article:
  1. What is inflation?
  2. What causes inflation?
  3. How is inflation measured?
  4. Effect of inflation on your investment
  5. What are real returns?
  6. Which investment option can help you earn inflation-beating returns?

What Is Inflation?

Inflation is the increase in the prices of goods and services over a period of time. It is commonly referred to as mehangai in HindiAs prices of goods rise, you have to spend more to buy the same goods. For example,
  • The cost of 1 Litre petrol was Rs 9.84 in 1990. Today, it is Rs 99.14.
  • 1 kg of wheat grains used to cost Rs 2.35 in 1990. It costs Rs 40 in 2021.
  • 1 kg toor dal would cost Rs 8 in 1990. It costs Rs 150 in 2021.
This is the impact of inflation. It reduces the purchasing power of money. The value of Rs 100 today will be Rs 11.34 after 30 years at a 7% p.a. inflation rate. With the above example, it’s safe to say that as inflation rises we can purchase fewer items for the same amount of money.

What Causes Inflation?

1. Increased money supply

Let's take the example of the famous oil-rich country Venezuela. Almost 90% of the country’s income was generated by exporting oil. But oil prices crashed in 2014. The country found itself in the midst of an economic crises. Bolivar which is Venezuela’s currency became worthless. As the government was falling short of cash, they started printing more money. Bolivar fell rapidly due to increase in its supply. This caused the prices of goods and services to increase further. This caused hyperinflation.

2. National Debt

If the country has more debt, then inflation is likely to occur. In case of Venezuela's economy, the country’s government kept printing more notes to pay off their debt. This continuous printing led to hyperinflation and the cost of goods rose by 6,500% every year.

3. Cost-Push Inflation

Cost-push inflation only occurs when input or raw materials costs rise. This increases the cost of production. This happens when the company is spending more on buying raw materials. In order to preserve their profitability, they pass the increased production cost to the customer in the form of the increased prices. This is one of the most visible inflationary forces.

4. Demand-Pull Inflation

Demand-pull inflation occurs when there is high demand but less supply of goods in an economy. It leads to a quick rise in prices. An example of this is the soaring prices of onions and toor dal a few years ago.

How Is Inflation Measured?

In India, inflation is measured by two main indices.
  1. Wholesale Price Index (WPI)
  2. Consumer Price Index (CPI)
WPI measures the changes in the prices of goods sold and traded in bulk by wholesale businesses to other businesses. It is classified into three major components.
Food Items Non-Food Items Manufactured Goods
Cereals, Pulses, Vegetables, Fruits, Milk, Eggs, Meat & Fish, etc. Oil Seeds, Minerals and Crude Petroleum Textiles, Apparels, Paper, Chemicals, Plastic, Cement, Metals, and more.
CPI measures the rise in average retail price of goods that households pay on a regular basis. It is a measure to understand the cost of living of individuals. CPI is used to set credit policy by the central bank.

Effect of Inflation on Your Investment 

You must have heard a lot about how power of compounding works. But have you heard of decompound interest? If not, let’s explore more about it. Decompound interest is the opposite of compound interest. In compound interest, your money compounds every year over the previous year’s returns. Similarly, inflation occurs every year on top of the previous year’s inflation. It means that the effect of inflation on investment is just like compounding. So what you earn from compounding your investment, inflation takes it away. This is the effect of decompounding. Let’s take a simple example. Suppose you have invested Rs 1 lakh for 10 years in an investment option which provides 7% returns annually. At the same time, the inflation rate of the economy is also 7% per annum. Here, the amount you earn every year is equal to the inflation rate. So, even if your investment corpus increases, it doesn’t add value. It simply means that the things you could buy today for Rs 1,00,000 will cost you Rs 1,97,000 after 10 years. So, practically you haven’t become any richer. Now let’s take another example. Suppose you don’t believe in investing. And you have Rs 1 lakh in your locker. Let’s see how inflation erodes the value of your money in the upcoming years if the inflation rate is 7%.
Year Amount
Start Rs 1,00,000
10 Rs 50,835
20 Rs 25,842
30 Rs 13,137
Effect of Inflation You can notice your Rs 1 lakh will be worth only Rs 13,137 after 30 years. That means your money is losing value every minute. Hence, there is a need to invest in assets which can provide inflation beating returns. How does all of these affect your investment? Effect of Inflation Let’s say you order a pizza. When the delivery man delivers it you notice that there’s a missing slice. This slice could be called inflation. It reduces your real returns. So, the interest you expect to receive is your nominal return. Then inflation takes a bite from it and the leftover pizza is the real return that you will get. Let’s say you are planning to retire in the next 30 years and your goal is to have an investment with a value of Rs 1 crore then you must plan with a bigger amount, say Rs 5 crore. Because in the next 30 years, the value of Rs 1 crore will be Rs 13 lakhs only assuming a conservative 7% inflation. Even the value of Rs 5 crores will be a mere 65 Lakhs! Now you know why considering inflation is important for your investment. But the question still remains - which is the investment option that can help you earn inflation beating returns?

Which Investment Option Can Help You Earn Inflation-Beating Returns?

Effect of inflation Sources: RBI website and NSE website

1. Equities

Liquidity High
Tenure Long- term
Risk  High
Who can invest If you want to invest for the long term and wish to earn high returns.
Risk-Reward ratio High
Investing in equities over a long period is one of the best ways to fight inflation. In the last 10 years, Nifty has generated a compounded annual growth rate (CAGR) of 17.60%. Even after accounting for a 7% inflation, your real return is still a decent 10.60%. This proves that equities have the ability to beat inflation. However, you can make even higher returns than the index if you buy the right stocks and hold them for the long term. Analysing every listed stock is a tedious job. Hence, Samco has come up with Stock Rating which evaluates every stock on a scale of 1 to 5 star. One star is for least investment worthy stock. And five is for the best investment worthy stock. Check out Stock Rating for any stock of your choice here. 

2. Equity Mutual Funds

Liquidity High
Tenure Long term
Risk Moderate
Who can invest If you are looking for a long term investment option with moderate risk.
Risk-Reward ratio High
Investors who do not wish to directly invest in the stock markets can invest indirectly through equity mutual funds. It provides the benefit of diversification. You can  invest according to your risk appetite and time horizon across different market capitalization like small cap, mid cap and large cap funds. In the last 10 years, large cap equity mutual funds have generated a CAGR return of around 11.82%. Hence mutual funds can also provide you inflation beating returns.

3. Gold

Liquidity High
Tenure Long term
Risk  Low
Who can invest If you wish to diversify your investment and want to hedge against inflation.
Risk-Reward ratio High
Gold is considered as a hedge against inflation. As inflation rises, the price of gold rises along with it. Historically, gold has generated 9.8% annualized return in the last 10 years. If you invest in gold jewellery, the making charges is quite high. It usually ranges from 6% to 14%. For those who want to buy gold for investment purposes, there is an alternative where you can buy paper gold in the form of gold exchange traded funds (ETFs). They are traded on the stock exchange with gold as the underlying asset.

4. Real estate

Liquidity Low
Tenure Long term
Risk  Moderate
Who can invest Investors who invest with the view of future appreciation of the property.
Risk-Reward ratio Depends on the location of the property.
Real estate is also considered as a good hedge against inflation. The value of property tends to increase as inflation rises. With property rates, rental income also increases. Hence, investing in real estate can be an excellent diversification to your overall portfolio. But the appreciation on the value of property depends on the location. It is an illiquid asset and is suitable for investors with a long term horizon. The Reserve Bank of India (RBI’s) House Price Index (HPI) considers 10 major cities and analyses the average return in real estate sector. The last 10 years, return of real estate is 11.60%.

5. Bank Fixed Deposit

Liquidity High
Tenure 7 days to 10 years (premature)
Risk  Low
Who can invest If you have a lump sum amount to invest for a fixed period.
Risk/reward  Low
Bank fixed deposit (FD) is indeed a great investment option for investors who have a low risk appetite and wish to have fixed income. But do they provide inflation beating returns? The answer is no. The current FD interest rate ranges from 4% to 6% annually. Whereas, the current inflation rate is around 6%-7%. If you invest Rs 100 in a bank FD, then after a year it will become Rs 104. But with a 7% inflation, the value of this Rs 104 will be Rs 97. So, your real return is a loss of Rs 7. Recommended reading: Mutual funds vs FD which is the best investment option in 2021 This reminds me of the famous quote of Robert OrbenInflation is the crabgrass in your savings. Yes, that’s true. Inflation affects each rupee you earn. Therefore, it is important to choose investment options which have the ability to beat inflation. Out of all the above investments, the most effective investment to fight against inflation is equities. But not all stocks are worth investing. To create wealth in the long term you need to find the right stocks to invest. Start using Samco’s Stock Ratings Page right away to invest in equities and earn inflation beating returns.

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