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Can Your Investments Outrun Inflation? The Power of Compounding

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Can Your Investments Outrun Inflation? The Power of Compounding
September 16, 2024

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In this policy, the investment risk in the investment portfolio is borne by the policyholder.

The concept of compound interest is often hailed as the eighth wonder of the world. It's a financial magic trick where your interest earns interest, which can lead to substantial growth over time.  

Let's break it down with a simple example. Imagine you invest Rs. 100 at a 6% annual interest rate, with compounding (growth on growth) happening annually. After the first year, you'd earn Rs. 6 in interest. But in the second year, the interest is calculated not just on your original Rs. 100, but on Rs. 106 (your original investment plus Rs. 6 as interest earned). This pattern continues, and at the end of five years, your investment would grow to Rs. 133.82, with an effective yield of about 6%. That sounds impressive, doesn't it? But there's a catch. The rate of growth doesn't tell the whole story. You will need to factor in the silent wealth-eater: inflation, a critical consideration when it comes to investments.

The Unseen Enemy

Inflation is the gradual increase in the prices of goods and services over time. It erodes the purchasing power of your money. In India, the current annual inflation rate hovers around 6%a. This means that what you could buy for Rs. 100 today might cost you Rs. 106 next year.  

Let's revisit our earlier example. If the inflation rate is 6%, your real growth is 0% (effective yield of 6% minus inflation rate of 6%). So, while your investment grew on paper to Rs. 133.82, its real value in today's terms is still closer to Rs. 100!

Why Inflation Matters

Inflation isn't just a theoretical concept; it has real-world consequences.  

If your investments don't keep pace with inflation, your savings will lose value over time. This is especially crucial for professionals, who are likely saving for major life goals like retirement or children's education.

The cost of living is constantly rising, and if your investments aren't growing at a similar or faster pace, you may find it challenging to maintain your desired lifestyle or achieve your financial objectives.

Think about it this way: if you save Rs. 10 lakhs today, it might seem like a substantial amount. But, due to annual inflation at 6%, that same Rs. 10 lakhs would have the same purchasing power as Rs 5.58 lakhs in 10 years or even lower at Rs 3.12 lakhs in 20 years!

It's like running on a treadmill – you need to keep moving forward just to stay in the same place. If your investments are not growing enough to counteract these rising costs, you may find yourself struggling to meet your financial obligations in the future.

Long-Term Options to Beat Inflation

To ensure your hard-earned money doesn't get eaten away by inflation, you need investments that can potentially outpace it. Two popular long-term growth options are Equity Linked Savings Schemes (ELSS) and Unit Linked Insurance Plans (ULIPs).

ELSS funds invest primarily in stock markets, which have historically delivered higher returns than inflation over the long term. However, they come with a lock-in period of three years (including each monthly investment), and are purely investment-focussed, offering no life insurance protection.

On the other hand, ULIPs offer a combination of life insurance coverage and investment opportunities, allowing you to grow your wealth while securing your family's financial future. They provide a more comprehensive solution for individuals seeking both wealth accumulation and protection.

ULIPs: A Closer Look

ULIPs offer a range of benefits. They provide flexibility in choosing your investment strategy, allowing you to balance risk and reward based on your financial goals. You can also switch between different funds as market conditions change, giving you the agility to adapt your investments to the dynamic market environment.

Moreover, ULIPs offer life insurance coverage of at least 10 times the amount you pay as an annual premium. Look at a plan like HDFC Life Smart Protect Plan.  A plan like this gives you the option to choose from 8 funds1 and different plans to choose from. You can also get a minimum assured benefit2 in the form of a capital guarantee in spite of market fluctuations.

This provides a safety net for your loved ones in case of an unfortunate event, and ensures that your family's financial needs are taken care of, even if you're not around.

With features like loyalty additions3, which can boost your corpus over time, and the option for systematic withdrawals, which can provide a steady income stream during retirement, ULIPs can be a valuable tool for building long-term wealth and securing your financial future.

Starting Early

One of the most critical factors in combating inflation is starting your investments early. The power of compounding works best over a longer duration, allowing your investments to grow significantly over time. Consider a scenario. Person A invests Rs. 5,000 monthly from age 25, earning 10% annually. Person B invests Rs. 10,000 monthly from age 35, same return. At 60, despite B's higher contributions, A likely has more due to 35 years of compounding vs. B's 25.

Mid-career professionals have a unique advantage in this regard. They typically have a stable income and a longer investment horizon compared to younger individuals. By starting their investments now, they can harness the power of compounding and potentially build a sizeable nest egg for their future goals.

Conclusion

Compound interest is undoubtedly a powerful tool for wealth creation, but it's crucial to remember that inflation can significantly impact your investment returns. By choosing the right long-term investment options like ULIPs, and by staying invested for a sufficient duration, you can potentially overcome the erosive effects of inflation and achieve your financial aspirations. Remember, the key is to start early, stay disciplined, and make informed investment choices.

References:

a. https://www.macrotrends.net/global-metrics/countries/IND/india/inflation-rate-cpi

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ARN: ED/09/24/15169

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Francis Rodrigues Francis Rodrigues

Francis Rodrigues has a decade long experience in the insurance sector, and as SVP, E-Commerce and Digital Marketing, HDFC Life, manages the online sales channel, as well as digital and performance marketing. He has had hands-on experience in setting up sales channels and functional teams from scratch over a career spanning 2 decades.

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Vishal Subharwal Vishal Subharwal

Vishal Subharwal heads the Strategy, Marketing, E-Commerce, Digital Business & Sustainability initiatives at HDFC Life. He is responsible for crafting and ensuring successful implementation of the overall organisation strategy.

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We at HDFC Life are committed to offer innovative products and services that enable individuals live a ‘Life of Pride’. For over two decades we have been providing life insurance plans - protection, pension, savings, investment, annuity and health.

Disclaimer

1. With unlimited free Switching. Available under Level Cover and Decreasing Cover

2. Available under Level Cover with Capital Guarantee and Decreasing Cover with Capital Guarantee plan options

3. Loyalty Additions available under this plan – a) Return of 2X to 3X Mortality Charge from 11th policy year, b) Return of 2X Premium Allocation Charge from policy year 10 to 13, c) Return of Fund Management Charge (FMC) on Maturity, d) Return of 2X of Investment Guarantee Charge on Maturity

HDFC Life Smart Protect Plan (UIN: 101L175V03) is a  Unit Linked Non-Participating Individual Life Insurance Plan.

Insurance Coverage is available in these products. For more details on risk factors, associated terms and conditions and exclusions please read sales brochure carefully  before concluding a sale.

Unit Linked Life Insurance products are different from the traditional insurance products and are subject to the risk factors. The premium paid in Unit Linked Life Insurance policies are subject to investment risks associated with capital markets and the NAVs of the units may go up or down based on the performance of fund and factors influencing the capital market and the insured is responsible for his/her decisions. HDFC Life Insurance Company Limited is only the name of the Insurance company, HDFC Life Smart Protect Plan (UIN: 101L175V03) is only the name of the unit linked life insurance contract. The name of the company, name of the contract does not in any way indicate the quality of the contract, its future prospects or returns. Please know the associated risks and the applicable charges, from your insurance agent or the intermediary or policy document of the insurer. The various funds offered under this contract are the names of the funds and do not in any way indicate the quality of these plans, their future prospects and returns.

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