While making an investment decision, Majority of us tend to focus on the aspects like safety of our principal and returns on our investments.
– I’m getting 9% pa in fixed deposits and its also safe
– I’m getting a guaranteed return over long period of time in a life-insurance etc…
Above are some of the statements that we tend to hear more often around us.
However, the returns that our investments are generating are just the “Nominal Returns” without accounting for impact of Inflation and applicable Tax-liability.
Real Return is the Return on your investment after adjusting for Inflation and Taxes
Inflation reflects the rise in costs of goods and services that we consume in our day-to-day life or in other words, reduces the purchasing power of your money over time.
Inflation is, effectively, negative compounding of your money over time as each year’s inflation occurs on top of previous year’s inflation.
Applicable Taxes are like expenses, paid either annually or at the time of redeeming your investments depending on the investment product and related applicable tax laws.
Impact of Inflation and Taxes on your Investments
Consider a situation where you invest 100,000 and it earns 8% pa (compounded) and inflation is also 8% pa (compounded).
|Duration||Nominal Value||Real Value – (A) (yearly taxation on gains- 30% slab)||Real Value – (B) (LTCG taxation @ 10%)||Real Value – (C) (LTCG taxation @ 0%)|
Real value is the future purchasing power of 100,000 after the specified time-horizon.
Impact of inflation is much more as the time-horizon increases – negative compounding at work.
(A) represents additional impact of taxation on traditional saving instruments like Fixed Deposits etc. net of inflation
(B) & (C) represents additional impact of taxation on Market-linked instruments like Mutual Funds net of inflation
Majority of us want to visualize investments only in nominal terms as the impact of inflation and taxes is extremely hard to internalize.
However, the reality is nominal returns can only offer “Emotional happiness” whereas Real Returns is the harsh reality of actual financial health of your investments.
Important aspects to consider to manage the impact of inflation and taxes
 First and foremost let the nominal returns on your investments also compound – don’t redeem interest/gains in the middle.
 Divide your accumulated savings and/or regular earnings into time-horizon buckets so that you can identify the right asset-allocation and related investment products
 While evaluating an investment instrument, besides nominal returns potential also consider the tax treatment of the gains.