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Showing posts with label Inflation. Show all posts
Showing posts with label Inflation. Show all posts

Wednesday, July 13, 2011

Returns Should Account For Taxes & Inflation

How much did your investments really earn last year? You can calculate a rate of return with simple math (don't forget dividends if any), but if you don't adjust it for inflation and taxes, you're not getting the real rate of return.

This is the difference between the nominal interest rate and the real interest rate. You want to know the real rate, since that is the only number that means anything.

Think of it this way: the nominal interest rate tells you the growth rate of your money, while the real interest rate tells you how much your purchasing power is growing.

Growing Money

For example, if you make a Rs. 1,000 investment that earns 8% in one year, you end the year with Rs. 1,080. In other words, your money has grown by Rs. 80 (we'll assume no dividends just to keep the illustration simple).

However if inflation is 3% for the year, your Rs. 1,080 is only worth about Rs. 1,050. Inflation devalues not only the interest you earned, but the principal too. Your real rate of return is only 5%.

Investors depending on dividend income or interest from bonds or other fixed-income securities are most directly affected by the costs of inflation.

If you hold a stock, the gains build up until you sell, so it may be possible to avoid the "inflation tax" if you can time the sale for periods of low inflation.

Stocks can generally weather the effects of inflation better than bonds or other savings instruments. Companies can pass on the higher costs of inflation to customers. Of course, this tends to keep the inflationary cycle going.

Taxes

The above exercise adjusted your rate of return for inflation; however, it was purely academic unless your investment was in a tax-deferred account or a tax-free investment.

The other deduction you need to take to reach the real rate of return is for taxes. You don't get to keep - in most cases - all the money you make. The government will want its share too.

Let's return to our example. You invested Rs. 1,000 and earned 8% nominal return for Rs. 1,080. However, inflation is running 3%, so your real rate of return is only 5% giving you purchasing power of Rs. 1,050.

Even though your Rs. 1,080 will only buy what Rs. 1,050 would one year ago, you still have Rs. 1,080 in your account and the government wants a piece. For simplicity sake, let's assume that taxes totaled 20% in your bracket and that this qualifies as a long-term gain.
The government will want Rs. 16 of your Rs. 80 gain in taxes. Now your real bank account is down to Rs. 1,064.

If we reapply the 4% inflation to what you will actually get to keep, we will come up with the real purchasing power your investment returned. This figure is Rs. 1,021 (96% of Rs. 1,064 = Rs. 1,021).

The ugly bottom line is this. Your Rs. 1,000 investment has bought you a real return of 2.1% increase in purchasing power over last year after taxes.

That doesn't sound like much, however if you run all investments through the same exercise, you'll find similar results.

Real returns don't sound as good as nominal rates of return, but they are the truth and not an illusion.

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.