Why should you care about Inflation?

inf3It’s a useful paradox: By learning more about how money affects our lives, we can make sure it doesn’t take over our lives, and by learning how to look after our financial capital, we can also take better care of our human capital. Inflation is the evil that we cannot control, but we need to consider it in our financial planning either it is for our retirement or for children’s education.

What is Inflation?

infSimply put Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. As inflation rises, every Rupee you own buys a smaller percentage of a goods or service. Bottom line is, when inflation goes up, there is a decline in the purchasing power of money.

For example if the inflation rate is 10%, a hair cut which cost Rs 100, might cost Rs 110 next year. Similarly Toothpaste which costs Rs 50 this year, might cost Rs 55 next year. For illustration purpose, let us take the cost of petrol and $(both have an impact on goods and service) over the last 25 years.

YearPrice of Petrol in RsPrice of Dollar in Rs
19901017
19951732
20002542
20054444
20105046
20156062

For the last 45 years, historical inflation rate averaged 7.7%, but if you take the last 5 years data, it is close to 10%. Based on the historical data you should plan for 8% inflation, for your long-term needs

Why should you care?

If you are planning for your kids education in next 5 to 10 years or your retirement in next 20 to 30 years, you need to plan your finances considering the inflation. For example to study an engineering degree if it costs Rs 5 lakh, considering 10% inflation it could cost around Rs 12 lakh after 10 years. Similar manner, if your living costs are around Rs 50,000 per month, in 20 years(after you retire), it could cost you around Rs 2 lakh per month.

inf1There is also some positive effect of inflation, if you own a real estate asset which generates monthly rent, you can expect the income to increase to counter the inflation effect, but if you have a Fixed deposit in bank, your post tax returns could be negative considering the inflation. Hence when you are doing asset allocation planning, it is very important to consider inflation friendly assets like equities, rent yielding real estate etc.

Bottom line:

Your favorite ice cream, which costs Rs 100 today, might cost Rs 300 in 2030(due to inflation) :-) , if you want to continue to enjoy it without thinking for a moment whether you can afford it or not, better start planning for it.

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