Do you remember the price you paid to buy one kilo of onions in 2007? And do you know the price of the same one kilo of onions in 2008? If you find out that one kilo of onions in 2008 is costing you more than what you paid in 2007 then you can easily blame it on inflation.

While generally speaking inflation means a general rise in the level of prices the textbook definition says inflation reflects the situation where the demand for goods far exceeds the supply of goods.

In short, inflation reduces the effectiveness of money as the medium of exchange. High inflation means it becomes difficult to place a value to goods because the value of money is falling.

That is what you could buy for Rs 100 today you will have to pay Rs 103 for the same if inflation increases at the rate of 3 per cent. This might sound small right now but after certain years this is capable of eroding your capital.

Especially for retirees who have invested in fixed deposits or debt products which gave them yields (profit after tax) of about 15 per cent a few years back. Any increase in inflation reduces their yields to that extent.

Inflation does not only affect the purchasing power of your money but also reduces the effective rate of return on your investments.

Inflation pinches...

Now let's get straight to the point as to how it affects your investments. The end product of your investment will not have the same purchasing power as it holds today. But how do we arrive at that calculation.

There are lots of articles on inflation but very few explain how to calculate it. Hence, let us concentrate more on this as it is the main crux of this article. Also let us see its effect on your investments.

What you as investors need to calculate is the Real Rate of Return.

Normally investors look at the nominal rate of return. Nominal interest rate tells you how fast your investment grows. The real rate of return gives you the growth in the purchasing power, which is what should actually matter to you and me.

Let us take an example to understand this concept.

Say an investment is earning 8 per cent per year for you. If you have invested Rs 1,000 then at the end of the year you will have Rs 1,080. This means that your investment has grown by Rs 80 -- the interest earned at 8 per cent on your capital of Rs 1,000.

The real rate of return can be calculated using the formula below:

[(1+ Rate of Return) / (1+ Rate of Inflation)] - 1 (Read 1+ Rate of Return divided by 1 + Rate of Inflation less 1)

For example let us assume the rate of return at 8 per cent and the rate of inflation at 3 per cent.

Then the real rate of return will be [{(1+8 per cent) / (1+3 per cent)} � 1]* 100 = 4.85 per cent.

In the above example, though you have earned Rs 80 on an investment of Rs 1,000, at the end of the year your investment will actually be worth Rs 1048.50 only.

Thus, inflation not only erodes your interest but the principal amount too. This is without considering the effect of taxes. Unless your investment is in tax free instrument we have to take into account the tax implications. Hence, the return should not only be adjusted for inflation but also for taxes.

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In the above example, the return is Rs 80 for one year. Taking 3 per cent as inflation the principal with interest is worth Rs 1,048.50 only in today's terms and not Rs 1,080 as expected.

If the interest earned is taxable then from Rs 80 earned you deduct the tax to be paid to reach at the actual return or yield or profit after tax.

Assuming you fall into the 30 per cent tax bracket, you end up paying Rs 24 as tax (Have not taken into account education and secondary education cess for simplicity purpose).

So from Rs 80 earned first you pay Rs 24 as tax which gets your interest down to Rs 56. Now your investment is worth Rs 1,056 on which you calculate inflation at 3 percent. It is then worth Rs 1,025 as of today which is only 2.5 per cent earned on your investment instead of the 8 per cent that investors normally believe.

Though the figures do sound depressing the actual impact on your portfolio depends on the type of your investment.

Equity

If you are investing in equities or equity oriented mutual funds, you may not have to worry about inflation.

Because in the long run the company's earnings increase at the same pace as that of inflation. The only hitch is, in times of high inflation the company's earnings might seem very attractive but inflation might be the real factor behind the good results.

Again, to get good earnings and to beat volatility an investment in equity is only advisable if you are in for a long term.

Debt

Fixed income investors (like investments in fixed deposits) are the hardest hit. Unlike in the past in today's time debt investment do not yield more than 8 to 9 per cent. If you take inflation into account then the real rate of return falls considerably.

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The interests earned from most of the debt products are taxable. From the above example the post tax and inflation-adjusted return of 8 per cent gives a return of 2.5 per cent only.

Gold

You might be wondering why I have mentioned gold. India has the highest consumption of gold globally. Initially or in fact even today investors buy gold to beat inflation. Gone are the days of 1970s or 80s when prices of gold would respond to an increase in inflation.

With the relaxation in regulation since 1990 gold prices have now aligned with international prices and have trailed behind inflation.

That is the rate of increase in prices of gold is not equal to the rate of increase in inflation or the former increases at a slower rate than the latter.

Worries for the elderly

Inflation generally causes the maximum anxiety for retirees. While it is also not advisable to completely invest in equity It is always better to spread your investments.

You have to plan your investments to beat inflation. This can be done by calculating the Present Value of your investment.

Say your investment is going to yield you a return of Rs 10 lakhs at the end of 10 years. So what we need to find is what would be the worth of that Rs 10 lakh in today's time. With this you can also determine the extent of fall in the purchasing power of money. It helps you to determine if it would be enough to sustain your current life style.

Assuming the inflation rate to be 3 per cent the present value (PV) can be calculated as follows:

PV = Future Value * 1 / Rate of Inflation^ Number of Years

In the above example, the PV of Rs 10 lakhs would be Rs 10,00,000 * (1/3)^ 10 = Rs 7,44,094

This is useful especially when you are expecting the returns from your traditional insurance plans or any other products which gives you a lump sum return after a long time period.

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Hence it is always advisable to start saving from a very young age. It does not have to be a significant amount. You can start with as low as Rs 100 per month and increase it as and when possible.

For long term goals you can opt for systematic investment plans (SIPs) in equity oriented mutual funds or if you can follow your investments in stock market then invest in blue chip companies. By investing in debt products it is difficult, though, to beat inflation but in the short term you cannot avoid them.

The effects of inflation is relatively less in short run as compared to the long run. For short term you can invest in debt products that help you beat inflation like investing in short term liquid funds or in fixed maturity plans rather then going for fixed deposits.

Though every one knows about inflation what matters is how many of you actually take it into account while calculating your returns. Inflation plays an important part in deciding investments so do not forget this vital factor while deciding to invest.

The author is a financial consultant and can be reached at dhanplanner@rediffmail.com