How inflation cost influences investment planning

We often hear about investment opportunities offering double-digit market-beating returns that will create wealth and will guarantee a financially secure future and a dignified life. However, returns in themselves don’t signify much without the corresponding inflation figure. Inflation is the rate at which the cost of living grows. Another way to look at inflation is the rate at which wealth erodes.

To give a quick example, suppose a sandwich costs Rs 30 and the annual inflation is 10%. This means that the same sandwich next year will cost Rs 33, which implies that unless income levels increase by at least the inflation rate of 10%, affording the same number of sandwiches will not be possible. Inflation rates are critical in calculating the real rate of return for any investment. An investment scheme offering 8% annual return when the annual inflation rate is 9% is meaningless as the real rate of return is actually -1% (8%-9%).

Taking inflation into account is also critical when planning for different goals in life like securing children’s education, saving up for vacations, creating a retirement corpus and building emergency funds as levels of inflation will affect the risk appetite of an investor. Creating a retirement corpus to secure the golden years of life requires a very different kind of planning than building emergency funds.

While both inherently aim at creating wealth, the nature of the investments needed to achieve these goals are very different. Selecting appropriate funds and gauging the correct level of risk appetite and the investment horizon needed to build the requisite corpus can be daunting for an individual investor. Axis Mutual Fund’s Planning and Solutions has multiple online calculators to make these decisions easier and smoother.

Here are a few
examples:

1. Children’s Education: According to the National Sample Survey Office(NSSO), the average cost of education increased by 175% between 2008-2014, translating to an annualised inflation of 10-12%. Axis Mutual Fund has a simple calculator that can make planning your child’s future easier. All you require is the amount you need, the investment horizon (a maximum of 10 years or 120 months), your expected rate of return and your risk appetite. While deciding your expected rate of return, it is important to take the inflation rate into account. An inflation of 6.5% to 7% is pragmatic and helps one in having realistic rates of return. Suppose, you want Rs 2,000,000 in 10 years and you expect an annual return of 9%, inputting these in the calculator promptly gives an Systematic Investment Plan (SIP) amount of Rs 19,963 with your investments being allocated in a mix of equity, debt and schemes. The capital allocation in the equity scheme is 50% with debt following at 35% and 15% to hybrid. For this example, a conservative risk profile was chosen. However, with an aggressive risk profile, while the SIP amount stays the same, the allocation to equity jumps to 75%. This is natural as with a higher risk appetite more funds are allocated to high-return equity schemes.
2. Retirement Planning: Retirement planning entails long investment horizons. Considering a mean retirement age of 60 years, investors can have a massive 30-year investment window even if the earlier you start the more opportunity you have to maximise returns. Retirement planning makes a good case to have a high equity mix in your mutual fund portfolio as equity returns stabilise over longer terms. Axis Mutual Fund’s Retirement Calculator makes it seamless to visualise various scenarios with different investment horizons and risk profiles. Varying the risk profile makes it easy to see how capital allocation varies among equity, debt and hybrid schemes. For instance, if the risk-averse profile is selected with a corpus requirement of Rs 2,000,000, an investment horizon of 10 years and expected returns of 9%, the entire capital is invested equally between debt and hybrid funds; there is no equity in the mix. However, if the risk profile changes to growth, the entire capital allocation changes, now 75% of your funds are allocated to equity funds with debt and hybrid funds making up a combined 25%. Trying out various combinations gives an intuitive feel for the relationships between the different factors that will influence the overarching investment decision.
3. Vacations: Vacations are short-term plans. This is very different from retirement planning and planning for your child’s education as these are both generally long-term plans (any investment horizon longer than five years is considered long-term). As such, the choice of funds and the capital allocation in equity, debt and hybrid funds will change dramatically. Using Axis Mutual Fund’s Vacation Calculator, we can see that for a risk-averse investor profile, a retirement corpus of Rs 5,00,000, an investment horizon of two years and an expected return of 9%, the capital is entirely invested in a highly liquid short-term debt fund. As the risk profile gets more aggressive, equity and hybrid funds are included but the majority of the capital is still invested in short-term liquid debt funds.
4. Emergency Funds: As the world woke up to the pandemic, a human crisis unfolded affecting lives and livelihoods. Loss of incomes and a fear of an uncertain future made several realise the critical component of emergency funds. As hospital bills rose and as members of the workforce battled to save the lives of their near and dear ones, an overburdened medical sector signalled the need for investing in healthcare, especially among millennials.

Emergency funds vary between short-term and long-term funds. Using Axis Mutual Fund’s,
Emergency Funds Calculator
various scenarios can be simulated. In general, as liquidity is key for these funds, these investments will have a high portion of capital allocated to short-term liquid debt funds for short- to medium-term emergencies.