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Friday, October 12, 2012

Consider Inflation while Making Investment Plans

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External factors such as inflation, government regulations, interest rates and volatile stock markets can have a major impact on the financial planning exercise of an individual. These factors, especially inflation, hurt our standard of living. Rising prices mean you have to pay more for the same goods and services. If your income increases at a slower rate than inflation, your standard of living declines even if you are making more money. When we consider an investment option or a financial product, we need to evaluate the expected rate of return in real terms, i.e. if an investment option offers 10% pre-tax return in 1 year and the current inflation rate is 5% then the 'real' pre-tax return from the investment is approximately 4.8%.


Interestingly, however, a survey conducted by HDFC Life in association with Value-Notes (a leading provider of market intelligence and research) reveals that only 30-36% consumers take inflation into account during financial planning. It was surprising to note that people do not acknowledge that the external factors can significantly impact financial needs.


The survey results show a low level of financial literacy in urban India, both in terms of events (expected, unexpected, and external factors) that need to be considered and the product choices available to mitigate the various life risks. A deeper reading of the findings reveals that consumer awareness (aggregate score of 28.2 on a scale of 0-100) about important events around which they need to plan finances, borders on being extremely poor. Although they score better (aggregate score of 58.3 on a scale of 0-100) in terms of knowledge about the various financial instruments available, the score still falls in the low range. This indicates that although urban consumers have some level of knowledge about various financial products, they appear completely out of sync when it comes to deciding where, when and how they need to allocate their finances.
These findings bring to the fore the core essentials of a financial plan as below:

Identify and quantify your goals

Once the goals are identified, you may approach the target investment across diverse financial asset classes – fixed income, market-linked insurance products etc. However, to arrive at the investment target, you must consider external factors, especially inflation. Let me cite an example. You are 30 years old and plan to retire at 60. Your current annual expenditure is . 3,00,000. This means you would need a corpus in excess of . 2,00,00,000 to maintain your living standards, assuming you live till 85 years and the inflation rate is 4%. To build this retirement corpus, you need to invest . 3,60,000 per annum in a retirement plan that offers 8% returns per annum. Now, how do you arrive at a savings figure that you will need to cover your liabilities and family needs if you die prematurely? Let's consider a healthy 25-year old guy with an income of . 1,00,000 per annum. Let's assume his income will increase at a rate of 10% per annum, while the inflation rate will be 4%. At 50 years of age, his real income would be around . 10,00,000 per annum. However, in case of his unfortunate demise at an early age of 42 years, the loss of income to his family would be nearly . 5,00,000 per annum. This means, if he is investing in a protection plan, he must aim for . 10 lakh life cover.

Revisit, evaluate & realign your investment

Once you have zeroed in on a financial plan, it is important to revisit, evaluate, and realign it periodically. For example, if you have invested in an equity-linked product for your retirement, and if you are nearing maturity, you should consider shifting the corpus to a debt-fund for security of the returns on investment. Certain government regulations or interest rate changes can have an impact on personal finance. Financial plans must be revisited and evaluated in line with macroeconomic situations and life stage needs. A visit to a certified financial advisor can serve useful.

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