The impact of inflation on your SIP returns

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Systematic investment plans (SIPs) are a mutual fund investment tool for building wealth over the long run. However, one important factor that can affect SIP returns is inflation. Inflation eats into the purchasing power of one's savings and investments over time. While SIPs may generate potentially reasonable returns, a portion of those returns gets eroded due to inflation. It is, therefore, important for SIP investors to understand the impact of inflation on SIP returns.

This article discusses in detail the impact of inflation on SIP investments and strategies investors can adopt to enhance the real returns from their SIP investments.

  • Table of contents
  1. Understanding inflation
  2. Impact of inflation on SIP returns
  3. FAQ

Understanding inflation

Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When inflation occurs, each unit of currency buys fewer goods and services. Moderate inflation of around 3-5% is considered healthy for an economy as it indicates that demand is growing. However, high inflation of above 5-6% poses problems as the purchasing power of consumers and investors reduces significantly. Central banks try to control inflation and maintain price stability through monetary policies like interest rate adjustments.

Impact of inflation on SIP returns

Impact on real returns

While SIPs have the potential to generate returns based on the mutual fund scheme chosen, a portion of these returns gets neutralised by inflation. For example, if the inflation rate is 5-6% annually and a SIP generates a nominal return of 10%, the real return for the investor after accounting for inflation would only be around 4-5%. The higher the inflation, the more it eats into the real returns generated from SIPs. Investors must factor in the likely inflation rate over their investment horizon to arrive at realistic expected returns from SIPs.

Need for higher targets

Given steady inflation of 5-6% in India, investors may aim for higher targets over the long run to beat inflation. For example, if an investor wants to build a corpus of Rs. 1 crore after 15-20 years for their child's education or marriage, they may need to target nominal returns of 12-14% instead of the more commonly quoted 10-12%, to achieve the corpus goal in real terms after accounting for inflation. Not adjusting targets for a rising inflation rate can derail long-term financial goals.

Stagflation is a double-edged sword

Stagflation refers to a situation of high inflation combined with low economic growth. This could be a huge threat to investors as it could impact both returns as well as purchasing power. During periods of stagflation, equities as well as other asset classes may see subdued returns, compounding the erosion caused by high inflation. Investors must factor in the risk of stagflation while estimating long-term returns and revising goals.

Impact varies by asset class

Not all asset classes and schemes are impacted equally by inflation. Assets that tend to maintain or grow their value in line with inflation, like equities and gold, tend to offer a greater hedge against inflation, although this is not guaranteed. Within equities as well, multi-cap funds and large and mid-cap funds may sometimes offer more stability than small-cap or thematic funds. Similarly, among debt assets, gilt funds may sometimes fare better than credit risk funds during periods of high inflation. Therefore, factoring asset allocation based on an investor's horizon and inflation expectations is important.

Staying invested is important

While inflation erodes returns, withdrawing investments prematurely can compound losses. With equity SIPs, staying invested through market volatility and avoiding emotional decision-making is recommended. Studies show equity returns outpace inflation by a healthy margin in the long run. According to data from NSE, equities have delivered average annual returns of 12-14% over the past 30+ years after accounting for inflation. Thus, disciplined long-term SIPs can help investors avail themselves of these inflation-beating returns.

Conclusion

SIP investments provide an effective vehicle to achieve long term goals, but unchecked inflation could undermine returns. It is thus essential for investors to factor in prevailing and expected inflation levels while setting financial targets from SIPs and constructing a diversified portfolio that provides an inflation buffer. Regular review and timely adjustments based on macro factors will help optimise SIP returns.

FAQs:

What is the relationship between inflation and SIP returns?
Higher inflation means the purchasing power of your money decreases over time. For SIP returns to be meaningful, they need to beat the inflation rate so that investors do not lose money in real terms. Investing through SIPs in equities or multi-asset funds helps beat inflation in the long run through capital appreciation and dividend income.

How can investors protect their SIP returns from the impact of inflation?
Investors should review their SIP portfolio periodically and redirect investments from funds that lag inflation to those with better inflation-adjusted performance. Maintaining a long-term view and continuing SIPs through periods of volatility can help optimise the return potential while protecting the investment from inflation erosion.

Can inflation completely wipe out the gains from SIP investments?
If inflation consistently rises much higher than the returns generated by SIP investments in funds with very low or no equity allocation, then it can potentially wipe out all the gains over a long period.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.