From the point of view of financial planning, inflation is required to be factored in while aiming for long-term financial goals concerning the purchasing power. For example, in case the predicated average yearly inflation rate is 6%, an investor is required to create a portfolio with a return potential of about 6% to retain the buying power.
In this regard, a portfolio that takes into account investment timeframe, risk tolerance and financial condition can address the concerns that may arise due to inflation.
While no one can prevent the complete influence of inflation on the portfolio, however, a few steps could be initiated to lessen the impact and retain the pace to meet financial objectives.
Diversification of assets: A combination of assets is required to generate a prospective return that can address the consequences of rising costs. A diversified investment profile involves distributing the investments over various assets and investments. The core idea is to balance out stronger returns from certain investments, which will compensate for lower returns in the case of others. Diversification is also known to improve returns irrespective of the risk level.
Difference in normal and real returns: Generally, normal returns highlight what an investment earns before taxes, fees and inflation. However, real returns are the actual worth of the returns, which is considered after the deduction of inflation and fees. When it comes to analysing returns, it is essential to look at the difference between the normal and real rates of returns. For instance, a bank pays an investor interest of 5% annually on the funds in the savings account. Now, if the inflation rate is currently at 4% per year, the real return after the deduction of inflation on the savings would be about 1%. Furthermore, if tax implications are taken into consideration, then the real return is likely to dip further.
Reinvestment-related technique called compounding: Reinvesting the interest income into fresh investments can help to reap better gains through compounding. The returns received on this increased capital will be greater than the amount an investor would’ve gotten if they had invested with a different principle. The extra payments can result in building a suitable amount over a span of time.
An investor also needs to take into account the frequency of compounding. Generally, interests are calculated based on different frequencies, which could be monthly, quarterly and annually. The shorter the compounding frequency, the more interest is earned, and the faster the money will grow.
Rajiv is an independent editorial consultant for the last decade. Prior to this, he worked as a full-time journalist associated with various prominent print media houses. In his spare time, he loves to paint on canvas.