Summary of this article
Inflation cancels compounding
Real returns matter
Plan in inflation-adjusted terms
It is often said that what compound interest gives, inflation takes away. Another way of looking at it is this: inflation works like reverse compounding. Just as your returns build on last year’s returns, inflation builds on last year’s price rise. And over time, its impact can be just as powerful.
Consider a simple example. You invest Rs 1 lakh in an investment vehicle earning 8 per cent a year. At the same time, prices in the economy are rising at 8 per cent annually. On paper, everything looks fine. After ten years, your investment grows to about Rs 2.16 lakh. But the problem is that the things that cost Rs 1 lakh today will also cost roughly Rs 2.16 lakh after ten years.
So, while your money has doubled, what you can do with it has not improved at all. The rise in the value of your investment is an illusion. Fundamentally, your purchasing power has not grown.
In fact, situations get worse when inflation runs ahead of your returns. Suppose your investment earns 8 per cent, but inflation stands at 10 per cent, and this continues for 20 years. Your Rs 1 lakh grows to around Rs 4.66 lakh. Sounds decent. But during the same period, prices rose much faster (inflation). What cost Rs 1 lakh earlier now costs about Rs 6.72 lakh.
In real terms, the purchasing power of your original Rs 1 lakh has fallen to roughly Rs 15,000. You are poorer, even though your bank balance says otherwise. Many savers do not realise this because they look only at the absolute number and not what that money can actually buy.
This is not a theoretical problem. In India, for long stretches over the last 30 to 40 years, inflation has been close to or even higher than the returns from many traditional deposits. Yet most people treat saving and inflation as two unrelated issues.
The core problem is that we think in nominal terms. Inflation works slowly and invisibly, which makes it hard to internalise its long-term damage. Investors need to change the way they think about money by always factoring in inflation-adjusted terms.
How to Factor in Inflation?
Always consider inflation while planning for your long-term goals. For instance, if Rs 1 crore sounds like a comfortable amount 20 years from now, it will not be if inflation averages 7 per cent. You will actually need closer to Rs 4 crore. Working backwards, even at an 8 per cent return, this would mean saving roughly Rs 68,000 every month. At 10 per cent returns, the monthly investment would come out to be Rs 55,000. At a 12 per cent rate of return, the required monthly amount comes to Rs 44,000.
Ultimately, the only way to protect your wealth is to make sure it grows faster than inflation. If your investments fail to do that, the numbers may look bigger over time, but your financial position is quietly slipping backwards. If you cannot plan on your own, get in touch with a financial planner and design your investment planning in a way that inflation does not hit you in the long run as you near your goals.
