I fondly remember the days when as a teenager I used to go to movie theater in an army cantonment and patiently wait for the interval to grab a dosa which cost Rs 2.50 in the early 90’s. Fast forward to 2014 and the same dosa costs me Rs 60. Ok, agreed, I eat in a restaurant these days, but you get a sense of the exponential increase in prices.
What causes an identical product with the same ingredients cost 10 times more in a period of 20 years, it is our first silent killer of wealth, INFLATION.
Inflation does not stop at food, it affects every area that touches our life. Just to give you a sense in numbers, a 8% annual inflation rate will increase the annual cost of your living from Rs 5,00,000 to Rs 10,00,000 in less than a decade. But 8% is not a hypothetical number, India’s average inflation rate from 1971 to 2011 was 8.04%. This has huge implications on multiple fronts but there is one that is very common and can have the most damaging effect on your ability to build wealth.
Let’s assume you as a family manage to save Rs 500,000 every year and put that money in a Fixed Deposit (FD) which gives you 9 % return on average. After 5 years, at an average inflation rate of 8.5%, will your Networth
b) Remain the same? or
If you answered a) or b) you are incorrect, the correct answer is c) and the prime accused for the answer, is our second silent killer TAXES.
Even if you are in the lowest tax bracket of 10%, the after- tax rate of return on FDs will be lower than the inflation rate and that’s how you get robbed of your wealth. Unfair, I agree after all you were practical in saving a sufficient amount of money and putting it in to a bank at a reasonable rate.
So, how do you compensate for the 2 silent wealth robbers? Below are some thoughts that you can put in to practice going forward:
- Include inflation and taxes in your consideration set before making any long term investment. You have to aim for an after tax return on investment that beats the inflation by at least a couple of percentage points. E.g. if you are looking at an investment horizon of 10 years and expect the inflation to hover around the 8% mark, you should invest in instruments that give you a compounded annual growth rate at least 10%.
- Do not let excess money lie idle in you bank savings account as Inflation will reduce its purchasing power even in the short term. This is what I do, every 3 months, I check the excess cash i.e. amount over and above my 6 months contingency fund and invest it in a FD for 3 months which gives me a return of 8.25% compared to 4% on the savings account. This small adjustment, which has no risk and takes less than 5 minutes of my time gives me an incremental return of over 4% which can be significant particularly, if the amount you put in FDs is in large.
- Invest in equity mutual funds and stay invested for more than a year to avoid capital gain taxes because if you sell out in less than a year, a capital gain tax will be slapped on you which will wipe out 15% of your gains just like that.
Though, majority of us are aware of tax saving alternatives, we seldom factor inflation and/or an appropriate inflation rate in our financial investments and that, can be a very COSTLY mistake.