Saturday, December 25, 2010

Impact of inflation

Impact of inflation

Running to Stand Still (or, the Impact of Inflation and Taxes)

Everyone knows that inflation eats into savings and increases costs (to understand how inflation can affect your cost of living, use our Cost of Living Calculator. But what a lot of people grapple with is how does one insure oneself against inflation? In this article we discuss why it is important to invest wisely particularly if you do not want to keep running (working hard) just so that you can stand still (maintain your current standard of living).

Consider the post-tax, real rate of return

Whenever you consider an investment option, remember to evaluate the expected rate of return in real terms. In other words, deduct your expected compound annual rate of inflation for the investment period from the compound annual rate of return that you expect from your investment.

For example, say you are considering a bank fixed deposit that promises you an 11% annual rate of return over the next five years and your expectation of inflation during this period is 7% (compound annual).

For this investment, your real compound annual rate of return is only 4%. If your income from this investment attracts a 30% tax rate, then your post-tax real rate of return diminishes further to 0.7% only! A number nowhere near the 11% that you might be using to evaluate this investment option!! An investment with such characteristics is a classical example of running to stand still.

Let's look at how you could improve your 0.7% return. If you are willing to take on a slightly higher level of risk, you could invest this money into an income mutual fund with a dividend investment plan option. Such an investment is likely to yield around 11% post-tax return (since dividend income from mutual funds is non-taxable). This would effectively result in a post-tax, real rate of return of 4%, far higher than the 0.7% that the bank fixed deposit would earn for you.

On a 10-year perspective, Rs10,000 invested today in bank deposits (yielding 0.4% post-tax, real rate of return) would be worth Rs10,722 whereas the same amount invested in an income mutual fund is likely to be 38% higher at Rs14,802. Presumably, this should compensate you for the slightly higher risk to which your investment is exposed. (To understand more about the impact of compounding returns on investments, see our article on the Power of Compounding ).

The above example highlights that inflation and taxes are important factors to consider while evaluating investment returns and how a little more attention to your investment decisions can result in a significant improvement in your financial health. (To understand the approach and benefits of financial planning further, read Guide to Financial Planning .)

Benefits of investing early

Benefits of investing early

In this article we discuss how, because of the power of compounding specially over a long period of time, the difference between starting to invest early versus starting late can have a significant impact on your wealth.

We'll elaborate this with the help of an example.

Let's compare two friends: Sonia and Peter. Sonia starts saving Rs750 per year from the time she is 15. After 15 years, she stops investing money to her nest egg.

On the other hand, Peter starts investing Rs5,000 per year when he is 30 and continues investing this amount every year till he is 60.

If both earn 15% post-tax return per annum on their investments, who will have more wealth when they retire at age 60?

Sonia. Her Rs750 annual savings between age 15 and 30 will aggregate to Rs27.7 lakhs by age 60, whereas, Peters Rs5,000 annual savings between age 30 and 60 will aggregate Rs25 lakhs.

Both will have built up meaningful wealth (compared to their investments). BUT for Sonia to build her wealth, the difference in the annual investment amount and the fewer number of years required for making investments, highlight the importance of starting to invest early.

To summarise, the power of compounding is the single most important reason for you to start investing right now. Remember, every day that your money is invested, is a day that your money is working for you.