Understanding inflation and what it means for your investments

We have heard several stories since our childhood about how the prices of everything used to be much lower than what they are right now, in the days of our grandparents. Something that used to cost Rs. 5 in 1950s costs almost 10 times more today, maybe even more. From the genera things of day-to-day requirement to housing, travel, assets etc. - the prices of everything have skyrocketed in the past decades and are increasing even today. The factor that causes this rise in the overall cost of living is known as inflation. Contrary to the popular belief, inflation neither a "modernistic" or post-independence phenomenon, nor is it limited to India or Indian subcontinent. Inflation is a very important factor in every economy, and even though the rates of inflation may vary, the average global trend has always been towards higher inflation.

Measuring inflation is a difficult problem for government statisticians. To do this, a number of goods that are representative of the economy are put together into what is referred to as a "market basket." The cost of this basket is then compared over time. It is a cascaded measurement which then results in a price index, which is the cost of the market basket today as a percentage of the cost of that identical basket in the starting year. In India, there are two major sets of inflation indices that are used to measure price level changes- Wholesale price index (WPI) and the consumer price index (CPI). Additionally, the Gross Domestic Product (GDP) deflator and the Private Final Consumption Expenditure (PFCE) deflator from National Accounts Statistics (NAS) provide the economy-wide inflation estimate on a wider basis.

Now, the impact of inflation on investments can be better understood. Investments are aimed at futuristic predictions and efforts towards increased purchasing power of a person. This simply means that a person invests because of the need of having better capital-at-hand or substantial capital gains in the future (depending on the term and the type of investment). Inflation goes directly against this. Consider this - Investing in shares can be risky because of market volatility, but it remains as one of the more effective ways to beat inflation.

Stocks depend on the performance of its underlying company more than market sentiment, which means a business that thrives may continue to create income for investors. This income may come in the form of share price increases or dividend payouts that can offset inflation.

However, the share market/just like the liquid assets can still be affected negatively by unexpected inflation.

Inflation rates directly affect this purchasing power or the capital gains. This happens because inflation rates vary and impact the prices of things by the time a particular investment matures and starts giving returns.

Understanding the sharp impact of inflation on your money investments is therefore, not just necessary but completely indispensable as well. If not duly taken into account, inflation rates can negate whatever significant capital gains you may have made from your investments.

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