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'Beware of inflation: it eats into your savings,' your financial advisor would have warned you a number of times. What you need to worry about it not just the inflation number that the government publishes every Friday, but the inflation that is relevant to you.
The traditional issue
One of the biggest differences between the number that the government estimates as inflation and the actual inflation that impacts you is the difference in the basket of goods and services that both take into account. So, for example, your biggest cost items like rent, children's education expenses or health care expenses may not find the same weight in the government numbers as they do in your monthly budget.
This concept has been written upon an implemented by financial advisors: they tend to advise you to take a buffer over the normal inflation rate and to account for higher inflation when it comes to goals like education. We will today explore a different concept called 'lifestyle inflation.'
What is lifestyle inflation?
As incomes go up, so do our living standards and desires. Alternatively, as the income and prosperity of a nation increases the options for the customer increases: especially in the luxury end of spectrum. As better choices start becoming available, there is a tendency to upgrade the lifestyle.
Consider, for example, going to the movies. Going to the movies, say, in the early 1990s, would have meant going to a nearby single-screen cinema theatre, the prices of which were determined by the government. A film at the threatre would have cost you Rs 30 then even in the best of the places. A ticket at a single-screen theatre would cost you around Rs 70-Rs 100 today, implying an inflation rate of 6-8%.
However, with multiplexes taking a big share from single-screen theatres because of better experience, watching a movie would cost you anywhere between Rs 150 to Rs 300, which translates into an inflation rate of 11% to 16%.
The incremental inflation (the difference between the higher 11-16% and the lower 6-8%) can only be explained by 'lifestyle inflation.' If you do hard number work, you will realize that as you move up in life, your expenses go up much more than the standard set that the government keeps track of.
This jump in lifestyle upgrading costs is the 'lifestyle inflation.'
You can witness a similar trend across all your expense items: your rent increases more than inflation as you start moving to better residential localities, you children's education costs go far higher than expected as you move them to better schools or colleges, your doctor visits cost you more as you start taking the help of specialists for your ailments, or your vacation starts happening at more exotic and far-off locations.
What can you do?
The most important thing to do is to recognize lifestyle inflation and then account for the same when you make your financial plan. The difficulty in recognizing lifestyle inflation lies in the fact that they are masked by income increases and hence hard to put a finger on.
You still end up spending the same 15% on of your income on rent and the same 10% on your children's education. Since your income increases at a fast pace, your lifestyle inflation is masked there.
Talk about your targeted lifestyle with your planner. Do you see major upgrades in lifestyles happening? Have you seen it happen in your life before? If so, be conservative in estimating the inflation numbers. Understand the implications of the inflation rates that your planner assumes.
Your financial plan is as robust as the assumptions that go into it: you can increase its robustness by validating the basic assumptions. Be careful -- and you will not be surprised later!
The author is Director, PARK Financial Advisors Pvt Ltd, Mumbai. He is an IIM-Ahmedabad alumnus. He can be contacted at email@example.com.
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