Inflation is a critical factor that influences the direction of your investments because it is at the heart of the returns you earn on your investments. Inflation is the rate at which a currency’s depreciation causes an increase in the prices of goods and services. Headline inflation has only a limited application in our daily lives. To realize the full potential of our investment portfolio, we must first understand the complicated relationship between inflation and investment returns.
Inflation has the greatest impact on investment returns on its own. The inflation rate indicates the rate at which our hard-earned money’s purchasing power is eroding. To maintain our current standard of living, we will need to increase our spending in the future.
As a result, the inflation rate should be the basic or minimum rate that any investment portfolio should return. We will be able to maintain our current standard of living if we earn returns on our investment portfolio that are equal to the current inflation rate. If, on the other hand, our investment returns exceed the current inflation rate, our purchasing power will increase, and we will be able to spend less just to maintain our current standard of living. To fully understand the impact of inflation on our investment returns, we must reconsider how we interpret headline inflation.
Using headline inflation of 23.6%, for example, to interpret the effects on your investment returns simply does not paint the full picture. Headline inflation is simply the sum of essential expenses such as food, transportation, and utilities. However, the average person’s expenditure exceeds the items in the inflation basket, and these items are not captured by headline inflation. Healthcare, phone bills, television subscriptions, and vacations are just a few examples. As the variety and magnitude of expenses increase, so does inflation. This means that the actual inflation rate that affects our lives is higher than the headline inflation rate.
The minimum inflation that should be used to evaluate purchasing power should be 2% to 5% above headline inflation. In this case, it should be between 25.6% and 28.6%. The benchmark for inflation must be revised as changes in headline inflation occur. Furthermore, because the inflation of different line items in the inflation basket is not the same, each financial goal must be accompanied by an inflation target. If you create an investment portfolio for a house, the return on that investment must be measured against housing inflation. The minimum inflation that should be used to evaluate purchasing power should be 2% to 5% above headline inflation. In this case, it should be between 25.6% and 28.6%. The benchmark for inflation must be revised as changes in headline inflation occur. Furthermore, because the inflation of different line items in the inflation basket is not the same, each financial goal must be accompanied by an inflation target. If you create an investment portfolio for a house, the return on that investment must be measured against housing inflation.
Nominal return = 19.08%
Tax rate = 0%
Headline Inflation rate = 23.60%
Real return = ((1+post tax return)/ (1 +inflation rate)) – 1
= ((1.1908)/ (1.236)) – 1
= -0.0367
= – 3.67%
Simply put, even though you made an investment with the intention of increasing your value, the real returns are negative. With such an investment, your purchasing power is eroded.
The real returns show us exactly how your purchasing power will change over time. As the name implies, real returns are the most realistic benchmark by which your investment returns should be measured, rather than nominal returns. It is acceptable to have a real return of 0% or higher, but a negative real return reduces your purchasing power. This example reflects your true investment performance and demonstrates how relevant the returns are to you in the real world.
A careful examination of a number of investments will reveal that, while their nominal returns appear appealing, they actually produce negative real returns.
