How to include impact of inflation in financial planning

For Vaibhav Nalwade and Pradeep Vishwakarma, two budding executives of ITES sector, inflation continues to be a puzzle as ever before. While they have been trying to figure out impact of inflation on their lives for quite some time now, the mystery of inflation is far from resolved. Their observation says that while key inflation indicator in India WPI (Wholesale Price Index) has been in the range of 8%-9% during last year, impact of inflation on their lives has been much more significant.  Their worry gets compounded by the fact that while inflation continues to reduce the value of income that they generate, even the value of investment made by them is getting fast eroded.

The experience of two budding executives should act as an eye opener for those who wish to minimize the impact of inflation on financial planning. While officially WPI is the number reflecting inflation in the country, for every individual impact of inflation is different. A man with low income gets hit more by food inflation than a person with relatively high income because of ability to absorb inflation shocks. So how should a person incorporate impact of inflation on financial planning, including management of money on day to day basis? There are two steps involved in measuring impact of inflation 1) Calculating Inflation and 2) Creating financial plan according to inflation.

Calculating Inflation: An investor should not just look at WPI numbers. It will be wise to prepare a cost sheet for similar kind of consumption items and monitor trends in cost. It is important to note that cost sheet should have similar kind of expense pattern. Any change in consumption behavior may not bring forward exact impact of inflation on life of a person. A typical cost sheet for one sample month in a year, over a period of time will like this:

This is just an indicative cost sheet and values mentioned are assumed values. But it highlights the method of calculating inflation for an individual. This cost sheet shows that effective inflation is 12.64% per annum over a period of 6 years while as far as inflation numbers are concerned they may say something else. It is important to note that only such consumption items should be included in cost sheet which are necessary consumption items and make impact of day to day. Luxury and other comfortable products should be ignored as such consumptions can be deferred.

Creating Financial Plan: Once inflation has been calculated,  impact of it needs to be take care of in financial planning. Future expense pattern can be driven by this and also future savings direction will come out of it. Additionally, the selection of asset classes should be done on its ability to beat inflation along with other features of safety and liquidity. Please remember that inflation will not always be double digit value only and hence traditional investment assets can also be selected for investment.

It is important to keep a watch of inflation. The most notorious enemy of wealth creation is inflation in India.