Inflation is effectively the reverse of compound interest. Take a closer look at the problem.
22-Feb-2022 •Research Desk
Believe it or not, Rs 1,00,000 in 2001 is worth just about Rs 27,000 now, all thanks to inflation. 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. To put it another way - inflation is effectively the reverse of compound interest; it's like decompound interest.
Consider a situation where you invest Rs 1 lakh in a deposit which earns you eight per cent a year. At the same time, prices are also generally rising at the rate of eight per cent a year. In such a situation, your compounding returns will just keep pace with inflation. The actual amount will increase, but what you can do with it will not. So while during a ten year period your Rs 1 lakh will become Rs 2.16 lakh, at the same time the things you could have bought for Rs 1 lakh will also cost about Rs 2.16 lakh on an average. 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. Thus, the increase in money that you have is nothing but 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 suppose your returns are eight 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. Your investment has actually made you poorer! This is not a theoretical example - it actually happens with millions of people in India. As over the past thirty to forty years, the inflation rate has been higher or at par with the interest rates of FD or many other deposits. Unfortunately, too many people think that the two problems are unrelated.
The inflation monster is destroying your wealth every year!
So many people earnestly saving their money suffer from the inability to account for inflation. People do not think in real terms i.e. they look at returns in nominal terms and awfully fail to consider the future impact of inflation. Remember, you 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 to amass Rs 4 crore after 20 years considering the returns of eight per cent. That's a depressingly large amount but it is what it is, there's no escape from the arithmetic reality. Now if instead of eight per cent, if you manage to earn 12 per cent returns, your monthly contribution would come down to Rs 40,000.
What this example actually tells you is that over a long period of time, you need a form of investment that sufficiently compounds your wealth beating inflation. In short, you need to embrace equity investing i.e. stocks. The value of Rs 1 lakh invested in 2001 in Sensex (a basket of 30 largest stocks in India) would have grown to around Rs 16 lakh till mid-2021! This is far ahead of the rate of inflation. Equity is the only asset class that beats inflation hands down over the long term. While a lot of investors think that equity is risky, it requires a little bit of critical thinking to realise that inflation is riskier. It is true that equity doesn't guarantee returns and can subject you to sharp ups and downs on a day-to-day basis. But the risk diminishes substantially over a longer time frame of five years or more. Equity and equity-linked investments are the only game in town to protect you from inflation.
To know more about how investments in bank fixed deposits and schemes like PPF are not enough to generate wealth and beat inflation, check out this video.