Impact of inflation on returns

Inflation eats into our earnings, savings and investments like insects eat crops, reducing and even destroying the agriculture produce. So how does one combat inflation to prevent our earnings, savings and investments from getting eaten up? In other words, how do we ensure that the rate of growth of our earning exceeds the rate of inflation or how the real rate of return on our investments is decent and positive. Here, we will not talk about how our earnings need to keep pace with or exceed the growth in inflation, but we will surely talk about how inflation eats into our returns on our investments and this can be countered with an appropriate mix of investments. 

The returns earned by your investments diminishes due to the adverse impact of rising inflation on the returns. Let us see how this happens. Suppose you invest Rs 1 lakh in a fixed deposit which fetches interest at the rate of 8% per annum. Now, if the inflation rate during the year was 5%, the real (inflation-adjusted) rate of return on your investments would be 3%, which is quite low as compared to your return expectation of 8%. The returns on investments diminish due to the depreciation in the value of rupee. So, after a year, the value of your investment of Rs 1 lakh would be Rs 95,000 due to inflation, while the value of interest amount of Rs 8,000 earned by you would be Rs 7,600. Hence, the actual return earned by you on the fixed deposit of Rs 1 lakh would be Rs 2,600 (95,000+7,600-1,00,000), which translates into real return of just 2.6%. 

Apart from the adverse impact of rising inflation, the tax on interest or dividend tax (in the case of mutual funds or equity investments) further reduces the returns on your investments. So, in this case, if your interest income is taxed at the rate of 30%, the tax you would be liable to pay on interest income of Rs 8,000 is Rs 2,400! Therefore, your inflation-and-tax-adjusted real earnings would be merely Rs 200 (Rs 2,600-Rs 2,400)! 

Hence, to combat the crippling effect of inflation, it is imperative that you invest in equity and equity-oriented mutual funds and debt mutual funds that can provide post-tax annual return of more than 10%. This, of course, calls for higher level of risk-taking, as equity mutual funds carry market risks and debt mutual funds carry interest rate risk.