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The inflation monster is destroying your wealth every year!

What compound interest gives, inflation takes away. Take a closer look at the problem

The inflation monster is destroying your wealth every year!

Believe it or not, Rs 10,000 in 1982 was worth just Rs 552 in 2018, all thanks to inflation. While you may earn compound interest on your savings, whatever compound interest gives, inflation takes away. To put it another way - inflation is effectively the reverse of compound interest; it's like decompound interest.

Since a year's inflation occurs on top of the previous year's inflation, this means that the effect is just like that of compound interest. Consider a situation where you invest Rs 1 lakh in a deposit which earns you 8 per cent a year. At the same time, prices are also generally rising at the rate of 8 per cent a year. In such a situation, your compounding returns will just about keep pace with inflation. The actual amount will increase, but what you can do with it will not.

So for example, during a ten year period your Rs 1 lakh will become Rs 2.16 lakh. However, at the same time on an average the things you could have bought for Rs 1 lakh will also cost Rs 2.16 lakh. In effect, you have not become any richer. The purchasing power of your Rs 1 lakh remains what it used to be ten years ago. And the increase in how much money you have is little more than an illusion, as it is completely negated by a corresponding rise in prices.

But inflation may not be so kind as to stay at the level of the interest you are earning. What if it's more? And what if this goes on for a very long time? Now supposing your returns are 8 per cent, but inflation stays at 10 per cent and twenty years go by, let's find out what happens.

So while your investment of Rs 1 lakh will grow to Rs 4.66 lakh, things that used to cost Rs 1 lakh will now cost Rs 6.73 lakh. Now, the purchasing power of your Rs 1 lakh is just Rs 69,000. Your investment has actually made you poorer! This is not a theoretical example - it actually happens to millions in India. In our country, over the past thirty to forty years, the inflation rate has been either the same or a little bit higher than the interest rates of many of the deposits that are available. Unfortunately, too many people think that the two problems are unrelated.

The inflation monster is destroying your wealth every year!

All these people earnestly saving away their money suffer from the inability to account for inflation. People think in nominal terms and the future impact of inflation is awfully hard to internalise. The real solution to this is that we should become a low-inflation economy, but until that happens, savers should always adjust for inflation mentally.

If Rs 1 crore sounds like the kind of money you'll want twenty years from now, then you will actually need to have about Rs 4 crore. If you work backwards from there, you will need to save about Rs 68,000 a month if the returns are 8 per cent. That's a depressingly large amount, but there it is, there's no escape from the arithmetic (you may make similar calculations quickly and roughly using the 'rule of 72').

What this example actually tells you is that over a long period of time, you need a form of investment that is inflation-adjusted. While a lot of investors think that equity is risky, it requires a little bit of thinking to see that inflation is riskier. And to match inflation, and to get real returns on top of that, you have to latch on to something that goes up with inflation. This is not difficult because the value of goods, services and assets in the economy is inherently inflation-linked. And so risky or not, equity and equity-linked investments are the only game in town to protect yourself from inflation.

This story was first published in April 2017.