- This topic has 7 replies, 5 voices, and was last updated Nov-195:33 pm by
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Up1
When presented with an inflation rate, we use it to increase the relevant expenses for the upcoming year. However, the inflation percentage is again added to the final answer. Is it because inflation is already reflected in the expenses, and the return needs to reflect the inflation percentage in order to maintain the real value?
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Up4
Sorry. Let me put it in a better way.
For example, The living expenses are $100,000, projected to grow at 4%inflation rate.
So the living expenses adjusted for inflation are $104000.
Say the required return(Funds needed/investable base) is 3%. The final answer is 3%+4%inflation = 7%.
My question was why do we add the 4% inflation to the final answer even though it is accounted for in the living expenses of 104000.
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Up4
Your adjusting to calculate the required real return. To fund the 4% increase in inflation and make 3% on the investment base you need to earn 7%.
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Up3
@AjFinance: I believe the question is to find the required rate for the next year. Hence we add inflation to the “Funds needed”.
The inflation added to the required rate is to maintain the purchasing power. -
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Up1
I agree with @sankrutimehta . I was confused because,
1. The inflation is already accounted for in living expenses.
2. It seemed like incorporating inflation effects twice.
But since meeting living expenses and also maintaining real value is the key, it makes sense to add inflation to the return%. Looking back, I partially answered while I was asking the question. :p
Thanks @sophie, @sankrutimehta and @pulltopar.
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Up1
It is a little confusing, and you’re right that it appears to be double counting on first sight. Despite the unfortunate wording, though, what they mean to say is that they expect their REAL living expenses to increase each year with the same level as inflation (i.e. they want to increase their real standard of living over time, they are not increasing their expenses for the purpose of keeping up with inflation there). Then, the rest should be clear – you calculate the real rate of return this way, and add inflation in order to maintain real value (so they can both increase their living standard by 4% each year and the portfolio principal keeps up with 4% inflation additionally).
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Up0
Yup @pulltopar (hello, welcome!) and @sankrutimehta are right.
The required return is a real return, so you need to take into account inflation so maintain the purchasing power in real terms (i.e. I can buy a Big Mac today at $1 and a Big Mac tomorrow at $1.04 – exaggerated example of daily inflation of 4%! ).
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