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Wednesday, September 22, 2010

Financial Planning to Beat Inflation

What is Inflation?

We observe that the prices of all goods and services keep increasing. Take anything - sugar, petrol, vegetables, cost of postage - anything, you would see that its price has increased manifold over years.

This is Inflation that what we always keep hearing about. And it can have a disastrous impact on your savings and investments. Reason enough to understand it better?

Understanding Inflation

Inflation means reduction in the purchasing power of the currency. Simply put, it means that the same amount of currency would be able to get you less goods (and services) over time.

For example, today rice costs Rs. 20 per kg. After a year, its price goes up to Rs. 22 per kg. This means that its price has gone up by 10%, or that the inflation is 10% for rice.

This means that for Rs. 100, you can buy 5 kilos of rice today. But after a year, you would be able to buy only 4.5 kilos of rice for the same amount.

Thus, the purchasing power of Rs. 100 has reduced, or, generally speaking, the purchasing power of the currency has reduced. This is known as inflation.

(Note: In practice, inflation is derived from the price movements of a very large basket of goods and services. In the example, for simplicity's sake, we considered only Rice).

This means that the value of a Rupee today is not the same as its value at a later time. This brings us to another interesting concept.

Time Value of Money

Through the example, we saw that the value of the Rupee keeps decreasing over time. The value is highest today, and becomes less and less as time goes by. Although the unit (the Rupee) remains the same, its purchasing power decreases over time due to inflation. 

That is only reason why we transact using 500 Rs & 1000 Rs note today which was not available in old days. Coins not is use with smallest denominations like 5 paisa, 10 paisa, 20 paisa, 25 paisa shows that we could not buy any goods or services using them now a days. Infact 1paisa, 2 paisa coins were also used half of the century ago.

Therefore, you can not compare an amount today with an amount at a later date without considering the time.

Say you lend someone Rs. 1000 today, and he returns Rs. 1000 after a year. Are you at par? No - because the value of Rs. 1000 after a year is not the same as its value today due to inflation. If inflation is 5% for the year, actual purchase power of your money is Rs. 950 only. In such a case, you can invest the Rs. 1000 today at the rate of 7%, and can get Rs. 1070 after a year to beat inflation.

How Inflation and Time Value of Money impacts your finances?

The fact that inflation reduces the purchasing power of Rupees over time has very significant impact on your savings.

Suppose, a post graduate degree costs Rs. 2,00,000 today. You are planning for your daughter's education, and want to save for it today when she is 10 years old. She would need the money after around 11 years.

How much should you plan to have at that time?

Rs. 2,00,000? No! It is not enough to save that much, because this amount would have lost considerable purchasing power in all those years.

You would need to have a lot more at that time, because due to inflation, the same service (post graduate education) would cost a lot more at that time.

This can be achieved if you do proper financial planning by determining your goals, check your investment profile & risk tolerance and start saving & investing based on your goals to beat inflation over a period of time.