Inflation Eating Into Your Returns? Power of Compounding Can Save It

June 2020

3 min read

 

Most of the Indian investors have at least one endowment plan in their portfolio. But have you ever thought about; why insurance companies sell endowment plans by telling you the amount you will get in the future; and not the exact rate of return?

If someone tells you that by investing 50,000 every year for 15 years, you will get 10 Lakhs at the end of 15 years. That looks like a good proposition. Because our brain is not trained to think in future value terms. If we include inflation at 4% in the calculation, then the value of 10 Lakhs is only 5.55 Lakhs after 15 years. And if we talk about the return generated in such type of products, it usually ranges between 4-6%.

For this very reason, most of the guaranteed return products fail to beat inflation; and in turn, generate very low wealth for investors.

How Inflation Impacts The Returns?

First, let’s understand what inflation is. In simple terms, Inflation is an increase in the prices of goods and services over a period of time.  Inflation is the most important aspect of every goal planning exercise and it cannot be overlooked. Let’s look at some of the numbers to understand how inflation increases the goal values:

Clearly, you cannot plan your goals without including the effect of inflation. But, where to invest? The traditional investment products like Fixed Deposits, Recurring Deposits, Endowment Plans have been the preferred investment options for Indian investors.

But the returns they generate are suboptimal. For example, In the current market scenario, FD returns have dropped significantly to 5-7% pa. These returns are hardly beating inflation. In such a case, to fulfill the financial goals, you either have to invest for a longer time period or increase your investment amount significantly.

But there is a way out of this. Compound interest can help you beat inflation to give you the desired return. But in order to get the benefit of compounding, you will have to invest in market-linked products.  Let’s understand how this works.

What Is The Power of Compounding?

Compounding is a mathematical phenomenon where when you invest your money, that money earns returns and that return also earns a return. This accelerates the growth of your investment. However, to get the benefit of compounding staying invested is the most important part. Here’s an example that will simplify the concept.

The amount that you could save by investing 5,000 per month at the age of 30, needs double investment if you start at the age of 35. The interest earned if you start at the age of 30 is 37.46 Lakhs, the same if you start at 35 is 31.95 Lakhs and for the age of 40, it is 22 Lakhs. Hence, one of the important factors for compounding to work in our favor is starting early.

Equity mutual funds are an excellent way to make compounding work for you. But most investors do not get to see this benefit because of their lack of patience. If you wish to generate returns that beat inflation, market-linked products are the way to go. But you need to give time for it to work.

As Albert Einstein famously said,

“Compound Interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

Using Investica’s goal planning module, you can plan for all your financial goals, taking inflation into account. Remember, your end corpus can be more than what you need but it can’t be less than what you need. Hence, make a note to invest in products that will beat inflation with a bigger margin over the long term.

For a specific fund recommendation, you can reach out to the Investica Support team and get a customized portfolio created to suit your needs.