What is inflation?

Inflation is defined as an increase in the price of goods and services over time, devaluing the currency’s buying power. Inflation can be broadly defined under two categories:

Demand-pull inflation – Excessive cash flow in an economy nudges an increase in demand for goods or services while production capacity for these goods and service remain the same. This scenario usually occurs in an economy that receives an influx of cash or credit stimulus.

Supply Side inflation – The rise in production costs due to inflationary pressure, like costlier raw materials needed to produce goods, leads to higher costs for finished goods or dispensation of services. This increase in production costs trickles down and adds to rising consumer prices.

Inflation is an inevitable circumstance. Incomes will rise as the economy expands, and as income rises, so will costs and inflation. Inflation is not necessarily a terrible aspect until it contributes to an abnormal price rise.

Equities and inflation

Theoretically, equity can act as a hedge against inflation since an increase in costs should correlate to the rise in revenues, which should increase share prices. On the other hand, this may be countered by shrinking profit margins when organizations’ input costs rise. Inflation’s impact on earnings may vary depending on the economic sector and its ability to pass rising input prices on to consumers. However, if input costs do not grow in lockstep with sales, an increase in profit margins may result in more significant real earnings. A moderate rise in inflation is advantageous for rising economies since stagnant or declining prices prevent the growth towards production and expansion. Most emerging countries face the dilemma of maintaining an appropriate level of inflation.

Impact of inflation on investors

Investors must focus on real returns on their investments.

Real returns = Actual return – Inflation

When computing inflation-adjusted returns, investors should include post-tax returns. If your investment returns outperform inflation over a suitably long investment horizon, you will accumulate money to meet various financial objectives. If your post-tax investment returns do not keep pace with inflation, you may be unable to accomplish your long-term financial goals.

Consider the case when inflation is set at 4% in any given year. If you invest your corpus in a fixed deposit that offers 5% actual yields, your real returns are merely 1%. The exact amount invested in equities, which offers actual yields as low as 10%, will earn you real returns of 6%. In such a scenario, investing in equities is more likely to assist an investor in meeting his financial goals than investments that offer returns below the percentage of inflation.

India’s average retail inflation between April and December this fiscal stood at just 5.2% (with food inflation under 3%), while it’s hovering around 7% even in the advanced economies.

Where to invest?

Merely saving will not suffice; investing requires a far more strategic approach if an investor wants to meet his investment goals. Over time taxes and inflation eat into your savings. Investors, therefore, need to keep in mind their financial goals and time horizon while investing. To build wealth, you must invest your resources in assets that can rise in value faster than the rate of inflation. Systematic Investment Plans (SIP) in equities via mutual fund route or through direct investments are ideal for long-term investing. They leverage the power of compounding and are especially well-suited for investments in an inflationary environment since they may profit from market volatility. The opportunity to invest systematically and periodically at multiple price points offers investors the benefit of rupee cost averaging, which is another plus point.