What is Inflation?

Inflation refers to a gradual rise in the price of goods or services that occurs over time, without any increase in their value. A soap that costs INR 20 today might cost INR 25 next, even though it has not changed in its quality or weight. Inflation is evident in the rise in chocolate bars’ prices.

You can see that inflation causes your cost of living to rise every year, even though you are consuming exactly the same products in the same quantities. If you earn INR 100 per year, then your income must increase to keep pace with inflation. Otherwise you won’t have the same standard of living as last year. If you want to improve your quality of life every year, a mere 8%-10% increase in your salary is not enough. What can you do to live a better lifestyle in the face rising prices?

Only smart investments can beat inflation. This means that your savings should be invested in options that offer a higher return than the inflation rate. Fixed deposits, PPFs and post office savings schemes are all options. These products won’t provide a return that is significantly greater than the annual rate of inflation, which is how much prices rise each year. What other options are there that will give you a significant increase in your return and help you grow your money? Equity is the answer. Only equity has the potential to beat inflation over the long-term. This asset class can be directly invested by selecting stocks from companies that you think are worth investing. If you don’t have the courage to trade on the stock exchange, you can still invest in this asset type through appropriate equity mutual funds.

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Let’s look at how equity mutual funds can help beat inflation. We will use an inflation calculator to help us illustrate. Inflation calculator allows you to calculate how much you will need in the future to pay for your current expenses. It will tell you how much you’ll need to pay for an expense costing Rs.100 in the future.

Let’s say you are 40 years old and your monthly household expenses is INR 50,000. Three years later, you are considering a trip to Europe and have spoken to your travel agent to find out the costs. For a 10-day trip, your agent estimates that it will cost you INR 4 lakhs. This is what the trip costs today, however. This 10 day trip to Europe will run you INR 4.63 lakhs if inflation is 5%.

You can save 4 lakhs by opening a savings account at any bank that offers 3.5% p.a. interest. After waiting for three years, your account balance will be 4.5 lakhs. You are still far from your goal. You could get 4.93 million if you placed this money in a bank FD that offered 7% for three years and then repaid it before you went on your trip. But don’t worry. If you are in the highest income tax bracket, interest income from bank fixed deposit income is taxable. You will have to pay 30% tax on this income. The bank will take a 10% TDS before crediting your FD maturity value. However, the 20% balance tax you have to pay on interest income when you file your Income Tax Return is 20%. Your FD amount will be INR 4.65 millions. You’ll also have to pay 30% tax on the interest income of INR 93.170. This is just to make sure you reach your target. Your target will not be reached if your FD pays less that 7%.

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We now return to equity mutual funds and equities. They are safer than direct investment in stocks for most people, who don’t want to trade stocks. Equity mutual funds have been providing more than 12% returns over a 3-year period. Long-term capital gains tax of 10% is applicable if you make capital gains exceeding 1lakhs. On any gain greater than 1 lakh, you will only pay 10% tax. Equity funds can be a great way to beat inflation and create wealth for a better future.

Mutual funds are explained in detail on the Mutual Fund Sahi Hai website, which is maintained by AMFI, an industry association. You can also access the different mutual fund calculators. If you are unsure about mutual funds or feel uncomfortable investing in them, this site contains a lot of information. Mutual funds can offer a greater return than most other savings options. Before you make an investment in mutual funds, you should be familiar with their workings and seek out the advice of a distributor.