Inflation is the enemy that is feasting on your returns even as you sit here reading this article.

When it comes to financial planning and making investment decisions, we generally tend forget to account for two critical factors -- Tax and Inflation.

Both these factors can significantly affect the 'net' returns available to us. Therefore, it is important for us to always calculate the 'post-tax post-inflation' numbers. While 'tax' is a subject matter in itself, let us look at what 'inflation' is all about and how it affects our financial health.

Inflation, in simple terms, means a general and progressive increase in prices of various goods and services; an economic condition of increasing prices over extended period of time. Don't we often hear our parents mentioning about high prices today and how things were so cheap 10-15 years ago.

A complex number

Inflation is measured by various indices such as Wholesale Price Index (WPI), Consumer Price Index (CPI), etc. One should keep the following points in mind when looking at inflation:

The WPI index is easier to determine and this is the inflation number that the government announces every week. But, being based on wholesale prices, it may not reflect the true impact of the rising prices on the consumer.

The CPI, though more relevant to an ordinary consumer, is difficult to calculate as (a) the consumer prices vary widely from place to place, (b) goods & services consumed by an urban consumer is different from a rural consumer, (c) even amongst urban consumer a blue-collar person's needs will differ from a white-collar one, etc. Hence, one number may not be applicable to all.

Further, the goods we consume change with time, but the inflation is tracked using a basket which is old and therefore does not truly represent today's consumption

The inflation number announced is a point-to-point calculation and does not capture the intra-year price movements

Even though the WPI has been mild at 4-6% in the last 1-2 years, it does not capture the steep rise in the prices of assets such as home, gold, equity shares. Therefore, even if one were earning say 8-9% returns on one's investment, the same will not be sufficient to buy a house today, where the prices have increased by more than 20-30%.

How does inflation affect the financial health?

Inflation erodes the value of money. It reduces its' purchasing power.

But the fact that (a) inflation is a slow killer as it has a small but compounding effect year after year and (b) it impacts the financial health indirectly, makes most of us overlook it's seriousness.

Suppose a weekend dinner at your favourite restaurant costs you Rs 100 today. And say the inflation is 6%. Then the same meal after 1 year would cost you Rs 106; Rs 134 after 5 years and Rs 179 after 10 years. Therefore, you need to ensure that your investments grow at a rate faster than the inflation to enable you to continue enjoying your week-end dinner.

To look at the issue in a different perspective, suppose you have Rs 1 lakh (Rs100,000). You don't trust anyone with your money so instead of investing it somewhere you have kept it in your locker. However, the inflation would have made the things costlier as years go by.

Therefore, what you can buy today with Rs 1 lakh, you won't get the same things in the future. This in effect means that the purchasing power of your Rs 1 lakh has gone down -- to about Rs 75,000 in 5 years and to only around Rs 56,000 in 10 years' time @ 6% inflation rate.

Many retirement plans ignore the inflation aspect. Say Rs 20,000 p.m. is your standard of living and you want to retire after 10 years and maintain the same standard of living.

Most people would plan their investments to give 20,000 p.m. returns 10 years hence, little realizing that its actual worth would have almost halved by then to only Rs 11,000. And its' value will keep eroding further year after year.

As they say, forewarned is forearmed. Once we appreciate the negative impact of inflation, we can provide for the same in our financial plan, rather than be surprised later with an 'inadequate' corpus. A bit of mathematical exercise will help keep us financially fit.

The author, Sanjay Matai, is an investment advisor. He can be reached at smatai@hotmail.com

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