How Inflation is eating up Value of your money?

Remember, the good old days, when everything, be it rice, sugar, potatoes, onions, milk, petrol, apples or utensils   were so much cheaper that have been available on the fraction of cost as it today. You may have noticed that prices of all essential household items have shot up considerably in the last few years. Prices of regular day-to-day items have risen significantly, in some cases up 30 per cent over the last two years. Prices of milk and cereals i.e. Daals have jumped 50 per cent in the last three years. That is what causes wallets to shrink. Typically, value of money loses its purchasing power when there is a persistent rise in the general level of prices in the economy, technically termed as inflation. It may appear tame in the short-term, but its effect sneak up on you after a long-period of time. If you have put away your money in an iron safe, do not be surprised if the actual worth of the money shrinks dramatically.

That said, “Inflation is when you pay fifty rupees for the twenty rupees haircut you used to get out for ten rupees when you had hair”

The Inflation bite

Inflation is a termite which is eating away your actual earning and reducing your standard of living without any alarming.  Just imagine, if you had painted your house a cost of Rs 1 lakh in 2013. You deferred the plan for a year and kept the amount in your savings account. In 2015-16, inflation went up by 10% (on an average). So, the expense of the paint job increased to Rs 1.21 lakh but you only have Rs1.16 lakh in your bank account. Due to the fall in the value of money, you will now need to shell out an extra Rs 6,000 for the same work thanks to inflation, over time, the value of the money saved could be much less than when it was earned. It is not the matter of fact that you would be probably arranging just Rs 6,000 to paint your house, it is the greatest threat to accruing wealth that how inflation swindles your money in the long-run. Buffet warns the investors how inflation is a far more devastating tax than anything that has been enacted by our tax law system. He advocates that inflation has a fantastic ability to simply consume capital.

For instance, “It makes no difference to a widow with her savings in an 8 percent passbook account whether she pays 100 percent income tax on her interest income during a period of zero inflation or pays no income taxes during years of 8 percent inflation. Either way, she is ‘taxed’ in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120 percent income tax but doesn’t seem to notice that 8 percent inflation is the economic equivalent.”

Compounding effect of Inflation

Let’s escalate our talk about inflation rate which is hovering in the range of 6-10% p.a. But the common problem is the inability to calculate its compounding effect among the people. They are prone to think in nominal terms, just like that of simple interest and the future impact of inflation is awfully hard to internalize. Put it simply as another way, inflation is effectively the reverse of compound interest, its like decompounds interest. For instance, if inflation is 10 per cent and your money is in a deposit of Rs 10 lakh that earns 8 per cent and twenty years go by?,  You are just reducing your money by 2 per cent compounded annually over 20 years.  Since inflation compounds, like compound interest its long-term effect is very large.  Your investment would grow to Rs.46.61 lakh but things that used to cost Rs.10 lakh would now cost Rs.67.20 lakh. Now, the purchasing power of your Rs.10 lakh is just about Rs.1.50 lakh meaning purchasing power of Rs.10 lakh has reduced by 10% every year for 20 years to Rs.1.50 lakh. Your investment has actually made you poorer though many may not have realized the same! In our country, over the past thirty to forty years, the inflation rate has been either the same or a little bit higher than many of the deposits that are available. Unfortunately, far too many people think of the two problems as unrelated. That’s a depressingly large amount, but there it is, there’s no escape from the arithmetic.

Summing Up

The important points in the preceding paragraph are that your money loses value over time, and you need to earn more than 8% on your money, just to stay even. When you consider rates of return, you must consider a number of factors. First, there is a nominal rate of return; this is the rate of return you earn before taxes and before inflation. Second, there is the real rate of return; this is the rate of return after inflation but before taxes. If the rate of inflation is 8% and you earn a 9% rate of return, your real rate of return (return after inflation but before taxes) equals approximately 1% (9% minus 8%). So, if you are planning for the future like retirement funding, it is worthwhile to consider allocating some portion of your portfolio to growth-oriented investments: assets that have the potential to increase in value (appreciate) relative to inflation over the long term. These include investments such as equity mutual funds, which may decrease in value over the short term but have historically provided returns well above the rate of inflation.

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