Can you believe it that what was worth INR 10,000 in 1982 is worth just INR 552 now, all because of inflation? Thus, even if you are earning a decent rate of compound interest on your savings, inflation is taking all of that way.
In other ways, inflation is like decompounds interest, since it reverses the effect of compound interest. Moreover, because the inflation for a year occurs on top of that of the previous year, its effect works out to be just like that of compound interest.
Let us take an example to understand this better. Let us say, you have invested INR 1lakh in a deposit, which gives you 8 percent in a year. At the same time, prices are rising at the same rate. In this situation, the returns that compounding will offer will be the same as the cuts due to inflation. Thus, while the actual amount increases, what you can do with the amount essentially remains the same.
After ten years, your INR 1 lakh will become INR 2.16 lakhs. At the same time, the same things that earlier cost you INR 1 lakh will now cost you roughly INR 2.16 lakhs. Which means that you have not become any richer.
The increase in the amount of money that you now hold is an illusion since inflation has negated the rise in your money.
What is worse is that inflation might be even more than what the rate of interest is. And what if this goes on for really long? Let us say, the returns are 8 percent, but inflation is 10 percent. And twenty years pass by. What would now happen?
Thus, while your investment would increase to INR 4.66 lakhs, things that earlier cost you INR 1 lakh would now cost you INR 6.73 lakh. Here, your investment has made you poorer! And this is not a theoretical example, this is what happens to millions of Indians.
Over the past three or four decades, the inflation rate has either stayed the same or has been higher than the interest rates that a lot of deposits offer. It is a great misfortune that many think that these two problems are unrelated.
A lot of people who diligently save their money than suffer from the inability to account for inflation. They only think in nominal terms, and they are unable to internalize the future impact of inflation. The only real solution here would be to become a low-inflation economy, but that is not possible either. Thus, until that happens, investors need to mentally continue to adjust for inflation.
If you want to save INR 1 crore twenty years from now, you need to have INR 4 crores. this means you need to save INR 68,000 a month, assuming returns to be 8 percent. This might come across a very high and depressing amount, but alas! There is no escape from this arithmetic.
What this example illustrates is that over longer periods you need to have a form of investment that is adjusted for inflation. And while investors believe that equity can be risky inflation can be riskier. To be able to match inflation and get real returns, you need something that goes up as inflation does. The value of goods, services, and assets is inherently linked to inflation. Whether risky or not the only game to protect yourself in town from inflation is equity.