What Is Inflation And How Does It Affect Your Investments
Ensuring availability of sufficient funds to sustain your current lifestyle in the future when you might not have any other source of income is the principal reason behind the investment exercise.
Thus, it is safe to say that you are estimating the future costs of leading your current lifestyle. While predicting the future costs, it is of utmost importance to consider the inflation factor, as the same is inevitable. Inflation is the rate at which the prices of goods and services increase, resulting in the decreased purchasing power of money.
Thus, inflation plays a critical role in your investment plans. Let us understand this in a little more detail by comprehending the different aspects of financial planning.
How does inflation affect your tax planning?
Tax payments are an unavoidable expense that you will have to account for as long as you have a source of income. You can profit from the income tax exemptions under the Income Tax Act and reduce your tax payments accordingly. If you are in the income tax slab wherein you do not have to pay any tax, you simply should move on to the next step of your financial planning.
Under Section 80C of the Income Tax Act, you can save up to INR 1.5 lakh in tax payments through tax-free mutual fund investments and other financial products. Having taken care of your tax planning, you need to move on to the next step.
How are your expenses affected by inflation?
Although it advisable to spend from what is left after saving, it is practically difficult to implement the same unless you have a thoroughly detailed expense management plan in place and adhere to the same.
In any case, you need to ensure that you spend on necessities and then if the balance after saving for your future, spend on luxuries. When accounting for your expenses you would notice the ever-rising costs of your necessities that have been depleting the purchasing power of your income. Based on the same experience you remain motivated to work hard, earn more, save, and invest more for fear of not having enough to spend on your necessities when you do not have any other source of income apart from your investments.
How are your savings affected by inflation?
Savings being the amount, you set aside for your short-term requirements, emergency, or liquidity requirements, help you limit your expenses to your necessities and leave the luxury expenses to your savings budget. This also gives you time to think through if you really want to bear that expense.
Investments in products like equity mutual funds (MFs) are for your long-term requirements and empower you to create and grow your wealth. The aim of both, savings and investments, is to ensure that you have enough money to meet future expenses. Expenses that are always under the influence of the prevailing inflation rates, affect the purchasing power of your income or savings.
How does inflation affect commodity prices and economic growth?
There are many factors that create inflationary pressure; commodity prices being the primary factor. For example, the increase in the price of crude oil directly results in the increase in the price of all petroleum products. This, in turn, results in the increase of transportation cost and thus an increase in prices of all other goods and services.
Inflation is also a by-product of strong economic growth, which boosts the demand for goods and services, leading to increased prices. It could also be an effect of the falling value of the rupee in the international market, making imports costlier and exports cheaper that result in poor national income.
In effect, inflation will always erode the purchasing power of your income, savings, and investments. Thus, when you are calculating the returns on your investments, you should reduce the earnings thereof by the inflation rate. That is if you are earning 7% interest on your fixed deposit (FD) and the prevailing inflation rate is 5%, then you are effectively earning 2% on the FD.
The same rule applies to mutual fund investments. Such investments require you to have a detailed and thorough financial plan in place. Followed by a comprehensive research on the available investment options in the market, you can achieve your financial goals. Such kind of research and analysis is rather technical and time-consuming.
You can choose to hire a financial advisor to manage your investment portfolio if you can afford the cost and risk. However, to avoid costs and seek personalized investment suggestions as per your risk profile, you can use ARQ, our proprietary investment engine, to carry out the requisite research and analysis, in order to help you choose the right MFs that aptly fulfill your needs. As an integral highlight of our Angel Bee mobile application, ARQ gives you simplified reports, free of human bias, after carrying out an in-depth analysis of the investment instruments, and thus enables you to make informed decisions on your investments.
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