Understanding the impacts of Inflation on your Savings
Table of Content
What is inflation?
Simply put, inflation refers to the rising cost of goods and services in a country. For example, if the fees for your child's higher education today cost Rs 10 lakh, it may likely cost much higher in about 5-10 years, say Rs 15-20 lakh, or even more. This would be due to the impact of inflation every year, which reduces your purchasing power and increases the costs of commodities and services, which is why it is an essential parameter you should not miss out on when doing financial planning.
What happens when inflation increases?
When inflation rises, it means the cost of goods and services is increasing, implying that to purchase the same commodities or services, you would need to now pay more due to inflation eating away your purchasing power. To tackle this and lower the impact of inflation on savings, you should factor in inflation when saving and investing money for the future. Otherwise, you would fall short of money for your set financial goals or would need to lower your lifestyle to buy whatever can be bought with the money you had estimated as per previous costs (that had not factored in inflation).
How does inflation impact your savings?
For example, let us assume an inflation rate of 6% per year. Now, the table below depicts how money eater inflation affects your expenses. Assuming a product costs Rs 1,00,000 today, here is how much its cost will increase over the years due to the impact of inflation.
Year |
Expense amount |
Starting year |
Rs 1,00,000 |
5th year |
Rs 1,34,000 |
10th year |
Rs 1,79,000 |
20th year |
Rs 3,21,000 |
25th year |
Rs 4,29,000 |
Note: Table calculations as per SEBI’s calculator-https://investor.sebi.gov.in/calculators/inflation_calculator.html and union mf calculator https://www.unionmf.com/knowledge-hub/calculators/impact-of-inflation-calculator
This calculation shows how the cost of a product keeps increasing through the years due to inflation, implying that something that is costing Rs 1 lakh at present can keep going up significantly over the years.
Now, let us also understand the impact of inflation on savings by seeing how much the present Rs 1 lakh would be worth in the future.
Year |
Expense Amount |
Starting year |
Rs 1,00,000 |
5th year |
Rs 73,390 |
10th year |
Rs 53,862 |
20th year |
Rs 29,011 |
25th year |
Rs 21,291 |
Note: Table calculations as per SEBI’s calculator-https://investor.sebi.gov.in/calculators/inflation_calculator.html and union mf calculator https://www.unionmf.com/knowledge-hub/calculators/impact-of-inflation-calculator
So, this calculator clearly shows how your purchasing power keeps diminishing with time due to the impact of inflation. Rs 1 lakh's worth in the future will keep decreasing significantly, implying that you will not be able to purchase the same goods & services with that amount in the future.
How do you prepare for inflation?
Three key ways to financially prepare for inflation and the impact of inflation on savings are as follows:
1. Build a solid investment plan:
Having a strong investment strategy in place can act as the first stepping stone towards your strong foundation for future savings. A solid investment plan that factors in inflation cost would ensure you accumulate adequate savings that do not get eaten up due to inflation and also do not diminish your purchasing power significantly.
2. Include inflation-protected investments in your portfolio:
It is absolutely crucial to include investments in your portfolio that offer returns that can tackle the impact of inflation. Investments that consistently offer inflation-beating returns can be helpful in tackling the ill effects of inflation and thus help you ride out the wave of rising prices, especially in the long term.
3. Spread out your investments:
Although traditional and safe saving options may offer you guaranteed returns, they might often not turn out to be sufficient to keep up with the rising inflation in changing times. That is why you should ideally diversify your investment basket to ensure your money is not only invested in safe or low risk instruments but also diversified into some market-linked instruments, especially for tackling and even beating inflation in the long run.
How to Protect Your Savings
The key step that you can take to beat inflation and minimize the impact of inflation on savings is to invest your money into an inflation-beating option that offers returns better than traditional fixed deposits or savings accounts. While such investing may involve relatively higher risk, that is still totally manageable since you would choose the investment instruments as per your risk appetite, such as debt mutual funds, bonds, stocks, equity mutual funds, gold, etc.
So, basically, you need to wisely do asset allocation so that you put your savings into a diversified portfolio that balances the ratio of risk and reward and, at the same time, consistently offers inflation-beating returns, which thus protects your hard-earned savings.
Two Main Ways to Fight Inflation
Diversification
One of the primary ways to tackle inflation is to go for a diversified portfolio by spreading your investments across various asset classes for instance equities, real estate, bonds, cash, gold, etc. Going for diversification helps to balance the risk and returns, thus providing a hedge against the rising inflation. Moreover, be sure to keep reviewing your portfolio, even if diversified, as this can enable you to make timely changes in your portfolio if any asset class is consistently performing below expectations.
Investment Focused on Growth
To prevent erosion of your money due to the impact of inflation on savings and to also grow your wealth, you must invest in instruments that generate either inflation-matching or inflation-beating returns. If you continue to neglect the cost of inflation, it could significantly diminish the value of your investments, thus jeopardizing your financial goals too.
That is why it is crucial to understand how inflation can affect your investments and how you can ensure you invest in instruments that are focused on inflation-beating growth. Such investment options include equities, gold, and real estate, as their historical returns have indicated that they have the potential to provide inflation-beating returns, especially in the long run.
Protecting Your Loved Ones from Financial Uncertainty
In addition to investing in inflation-beating options, it's essential to consider protecting your loved one’s from financial uncertainties with life insurance. Life insurance provides a financial safety net for your loved ones in the event of your untimely demise, ensuring that they can maintain their standard of living even if you're no longer around.
By incorporating life insurance into your financial plan, you can:
- Ensure that your family's financial goals, such as education and retirement, are still achievable even if you're not around to support them.
- Pay off outstanding debts, such as mortgages and loans, to prevent your family from being burdened with debt.
- Create a legacy for your loved ones, providing them with a financial foundation for the future.
Summary
Inflation can indeed pose a big hiccup if not factored in properly in your financial planning process. The impact of inflation on savings is that it reduces your purchasing power and erodes the value of your money over time, with an increasing cost of inflation. To prevent inflation from eating away at your savings, you need to factor it in during the calculation of future goals and investments and possess a diversified investment portfolio that offers inflation-beating returns.
FAQs on impact of inflation on savings
Q. Does inflation stop people from saving?
Inflation should not stop, but in fact, encourage people to save more money so that it does not eat away their money and diminish their purchasing power over time.
Q. Is it good to save money during inflation?
Yes. It is important to always keep on saving money, no matter how big or small you can. But to tackle the rising inflation, you should opt for investment options that have the potential to offer inflation-beating returns.
Q. How do you factor inflation into savings?
Since the inflation rate keeps changing every year, you need to assume an average expected inflation rate, such as 6% or 7% per year, and accordingly opt to save on investment options that offer better higher than the rate of inflation. You can use online inflation calculators to understand the impact of inflation on savings.
Q. What are the types of inflation?
There are many types of inflation that can occur in an economy, such as hyperinflation, open inflation, demand-pull inflation, cost-push inflation, repressed inflation, etc.
Q. What are the five negative effects of inflation?
The key negative effects of inflation include a reduction in purchasing power, an increase in the cost of goods and services, a rise in interest rates on borrowing costs like loans, the potential to lead to recession, and an adverse impact on returns from fixed income instruments such as bonds.
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