We all know the importance of investing. But what your investment advisers and investment gurus will not tell you is: how inflation is slowly eating up your investment returns!
But first, what is inflation? Inflation is the increase in general price level of goods and services produced in a country. It does not imply that prices of all goods and services are increasing in same proportion. While Prices of some goods may rise relative to other goods and some may fall, but on an average, inflation can still be positive.
Inflation affects us in two important ways. First, it reduces the purchasing power of your income and second, it wipes out the real return you gain from your investments. Just take a look at a simple example. If average inflation this year was 5%, it means that a product that was worth Re.1 last year, can be bought for Rs.1.05 this year. This also means that the purchasing power of your rupee is reduced by 5%.
Effect of inflation gets worse when it impacts the real return on your investment. This can be best explained with a much simplified example. Assume your investment earned a 10% return this year. But if the annual inflation this year was 4%, then the real return that your investment generated was only 8% (i.e. nominal return less annual inflation). This is primarily because during the year, your money has lost some purchasing power due to inflation and a part of the nominal return will be for recovering that lost purchasing power.