We all want our money to grow, but simply investing and earning returns does not create wealth. Inflation is a factor that eats up our returns and reduces the purchasing power of our savings. This is why choosing the right investment option is important, and that’s where the mutual fund comes into the picture.
In today’s blog post, we will give you an overview of how mutual funds can help us beat inflation and what real returns are.
Meaning of Inflation
Inflation refers to an increase in the price of goods and services over time. Whenever inflation increases, the purchasing power of money falls, which means you need more money to buy the same things. Incorporating inflation into financial planning is important for long-term goals so your investments can grow faster than inflation and you can achieve them. The inflation data is declared in terms of the Consumer Price Index on a monthly basis.
Can Mutual Funds Beat Inflation?
Yes, mutual funds can beat inflation, especially equity mutual funds that have the potential to generate higher returns over time. But these returns are market-linked and are not guaranteed, and it depends on the type of mutual fund which you are considering for investment. Generally, equity mutual funds have the potential to beat inflation in the long run.
How Do Mutual Funds Beat Inflation?
Mutual funds beat inflation in the following manner:
- Higher Returns: There are certain mutual funds, such as equity mutual funds, that primarily invest in stocks and equity-related instruments. The growth of such companies in terms of their revenue, profit, etc. can translate into higher returns for investors over the long term.
- Benefit of Compounding: Through compounding, your investment returns generate additional returns over time. The longer the investment horizon, the more opportunity your money has to benefit from this effect.
- Diversification: Through mutual funds, one has access to different asset classes and investment opportunities. It can reduce dependence on the performance of a single company, as diversified funds may invest across different sectors. However, it does not eliminate risk; it only helps in reducing market risk.
- Disciplined: Investing regularly through SIPs can help you become a disciplined investor. However, consistently investing does not guarantee profit; the return depends on the performance of underlying funds.
Which Mutual Funds Can Beat Inflation?
Mutual funds that primarily invest in equities, such as large-cap funds, mid-cap funds, small-cap funds, flexi-cap funds, etc., may help investors beat inflation, as these funds offer higher growth potential; however, their returns are not guaranteed. The following funds can help beat inflation:
- Large Cap Funds: These funds primarily invest money in large established companies that typically have strong market presence. This fund is suitable for investors seeking long-term capital appreciation with stability in the portfolio.
- Flexi Cap Funds: Such funds invest across market cap and includes large cap, mid cap and small-cap companies in portfolio. This investment flexibility helps the fund manager to exploit the opportunity.
- Mid Cap Funds: Mid-cap funds primarily invest in mid-size companies that have the potential to expand their business in the long run. These funds have higher growth potential than large-cap funds.
- Other than these funds, there are other mutual fund schemes that have the potential to beat inflation in the long run.
Read Also: High Risk vs Low Risk Mutual Funds: Which One is Right for You?
How to Calculate Whether Mutual Funds Have Beaten Inflation
To calculate whether your mutual fund investments have beaten inflation or not, calculate real returns such as:
Understanding Real Rate of Return: It measures how much your investment has grown after accounting for inflation. Nominal return only shows you the percentage increase in your investment’s value, whereas real return reflects the change in purchasing power.
Formula: The formula to calculate returns after inflation is as follows:
Real Return = R – I
= (1+Return%)/(1+Inflation)-1 * 100
Whereas,
R = Annual investment
I = Annual Inflation
Example of Mutual Fund Returns After Inflation
Let’s understand the mutual fund returns after inflation through an example
Mr A has invested 1,00,000 INR in a large-cap equity mutual fund, and after one year, your investment posted a return of 12%, whereas the inflation rate during the same period is around 6%.
The first step is to calculate the value of the investment after one year.
Initial investment = 1,00,000
Return = 12%
Calculation of Return = 1,00,000 * 12% = 12,000
Final Value of Investment = 1,00,000 + 12,000 = 1,12,000 INR.
Now let’s account for inflation.
Inflation is around 6%
The real return will be calculated using the formula
= [(1.12/1.06)-1]*100
Real Rate of Return = 5.66%
Factors to Consider Before Investing in Mutual Funds to Beat Inflation
The key factors to consider before investing in mutual funds to beat inflation are as follows:
- Investment Horizon: This is the key factor to decide before investing in mutual funds; it determines which category of investment is suitable for you. If you are investing for long-term goals of more than five years, you can consider investing in equity-oriented mutual funds.
- Risk Appetite: Investments in mutual funds carry various types of risk, such as market risk, credit risk, etc. Equity funds can be highly volatile and can significantly impact portfolio returns; therefore, before investing, you must understand the risks.
- Historical Performance: To beat inflation if one is investing in mutual funds, one must analyse the historical performance of mutual funds, such as how the fund has performed during market downturns.
- Investment Goal: Your financial goal must align with your investment objective, as a fund suitable for retirement planning will not be suitable for an emergency fund. You may consider diversification in equity funds only if you are comfortable with market volatility.
Common Mistakes to Avoid While investing in mutual funds to beat inflation
The most common mistakes that an investor makes while investing in mutual funds to beat inflation are as follows:
- Chasing Only High Returns: Chasing extraordinary returns is a common mistake an investor makes while investing in mutual funds. They generally invest in funds that have given extraordinary returns in the past; therefore, it is advisable that one evaluate the long-term consistency of the funds before investing in them.
- Ignoring Inflation: Most of the investors focus only on the returns that generally displayed in their portfolio without considering the impact of inflation. Therefore, one is required to always calculate the real rate of Return.
- Frequent Switching: Investors frequently switch between different mutual fund schemes that deliver better short-term returns. It may affect their long-term returns as they generally end up paying capital gains and exit loads.
Read Also: How does Inflation affect your Investment Portfolio?
Conclusion
On a concluding note, inflation used to eat into our investment returns for a long period of time and most of the investors are not aware of it. But with proper financial planning, we can brace ourselves for its impact on our finances. Mutual funds can help you build your wealth over time, with inflation-beating returns. And in this journey, equity mutual funds play a pivotal role; they have the potential to generate returns that can exceed inflation over time. However, equity mutual funds carry higher market risk and can post losses in the short term. Therefore, it is advisable to consult your investment advisor before making any investment in mutual funds.
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Frequently Asked Questions (FAQs)
Which mutual fund can beat inflation?
Equity-oriented mutual funds such as large-cap, mid-cap, small-cap, etc. can beat inflation in the long run. However, the performance of these funds depends on various factors such as market conditions, fund manager performance, etc.
What is real return?
The real return is the return which is calculated after adjusting for inflation. This is often known as actual return and tells us how much your money’s purchasing power has increased or decreased over time.
How does inflation affect mutual fund investment?
Inflation reduces the purchasing power of the returns earned by your mutual fund investment.
Does inflation affect the NAVs of a mutual fund?
No, inflation does not have a direct relation with the NAV, but it can indirectly affect the value of its underlying investments.
Why is inflation beating returns important in investments?
Inflation beating returns is important in investment because inflation erodes the purchasing power of your money over time. If your investment does not generate returns higher than inflation, you may lose wealth over time.
