When making investment decisions, you need to analyze the risk and compare it with the potential profit. For many people, the basic ways to multiply their savings are bank deposits and treasury bonds. However, there are situations when it will not be a profitable choice for us.
What is inflation?
Inflation is an indicator of the percentage increase in prices in an economy. It gives us information by how many percent the prices have increased compared to the previous year. It is always an average value, determined on the basis of the “basket” of goods and services. It is not a perfect indicator as prices never rise steadily. Some goods become more expensive, others less, and some become cheaper at this time. What matters is how much of our income we spend on basic items, how much is energy and media, and how much is luxury. There are years with seemingly low inflation, but with large increases in the prices of basic commodities, which have a heavy impact on the expenses of people with low incomes.
However, despite its general nature and simplification, it is a good indicator of a decline in the value of money.
What should be the purpose of our investment?
The basic premise when investing money should be to beat inflation. The real profitability of the investment can be calculated on the basis of the formula:
Nominal Investment Return – (Nominal Investment Return * Taxes on Profit) – Inflation
If the result is positive, the investment makes sense. It only depends on us whether we accept a given level of profit.
Example one – a term deposit at 2% per annum, with 19% tax on profit, with 3% inflation. The calculations will look like this:
2% – (2% * 19%) – 3% = 2% – 0.38% – 3% = – 1.38%
Nominally, the investment is at 2%. Including the tax on profit, we will get 1.62% interest after one year. However, with our money, we will be able to buy 1.38% less goods. We will actually lose on this deposit, but you have to remember that by keeping this money in your sock, we would lose even more.
Second example – lending money to a family member at 7% per annum, with 3% inflation. In this case, there is no profit tax because the loan is unofficial.
7% – 3% = 4%
In this case, we gain real 4% per year. Of course, the risk of investing is greater, as it may happen that a family member is unable to return the money.
It is worth taking into account inflation in the calculations before making the final decision about allocating your free funds. It may turn out that a potentially good investment will actually turn out to be unprofitable.