Understanding inflation and the need to invest

This article is the first in a series on Investing.

Most people don’t understand how big of an impact inflation makes to their personal finances.

I hear things like “investments are risky” and “Atleast, the money is safe in my bank account”.

Once we read this article, we will understand that keeping money in a bank account is actually more “risky” than investing that money.

Confused? Let’s try and understand why that is the case.

What is inflation?

“In economics, inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy.”

Let’s say that you currently pay Rs 200 to buy a cup of coffee of your choice from Starbucks.

In the last 15 years, India has witnessed an average inflation rate of 7% per year (Source). Meaning that, on average, the price of all goods and services goes up by 7% year on year. Therefore,

After 1 year, your coffee will cost 200 + (7% of 200) = 200 + 14 = 214
After 2 years, your coffee will cost 214 + (7% of 214) = 214 + 15.12 = 229.12
And so on…

Therefore, with each passing year, you are paying more for the same good/service. It is not necessary that prices of all goods and services will grow at a rate equal to inflation. We are just assuming the average rate here for illustration.

The impact of inflation

Now that we have an idea about what inflation is and how much extra money we’ll need to be able to buy *the same cup of coffee* every subsequent year, let’s try and understand what happens if we keep money in our savings bank account.

As we assumed above, we need Rs 200 to be able to buy a coffee from Starbucks today. Now, let’s say that we have put the same money in our bank account.

Let’s compare the rate of growth of that Rs 200 in our bank account with the inflation rate. Most popular banks in India promise a 3% return on savings bank accounts.

Here is a table which compares the rate of increase of the price of coffee with the rate of increase of the money in our bank account to buy that coffee:

Time	Cost of coffee (grows at 7%)	Money in bank account (grows at 3%)
Today	200	200
After 1 year	214	206
After 2 years	229	212
After 3 years	245	218
After 4 years	262	225
After 5 years	280	232
After 6 years	300	239
After 7 years	321	246
After 8 years	343	253
After 9 years	367	261
After 10 years	393	269
After 11 years	421	277
After 12 years	450	285
After 13 years	482	294
After 14 years	516	303
After 15 years	552	312
After 16 years	591	321
After 17 years	632	331
After 18 years	676	341
After 19 years	723	351
After 20 years	774	362

Some things which are evident from this table:

• After 1st year, we can’t buy the same coffee from the Rs 200 we saved in our account. Why? Because the cost of coffee has grown to Rs 214, but we only have Rs 206 in our bank account. This happened because the rate of inflation is much larger than the rate at which money grows in our bank account.
  
  This means that with each passing year, our purchasing power is actually decreasing because the cost of goods and services in the economy is growing as a much faster pace than the rate at which money grows in our bank account.
  
• After 20 years, the same coffee costs Rs 774 but our bank account only contains Rs 362. What? Now we don’t even have 50% of the amount needed to buy our coffee?

Now, think about all the products and services we buy. It can be a car, a house, a smartphone, clothes, petrol etc.

We might save money in our bank account to buy any of these things but some years down the lane, it will not be enough.

Our hard earned money parked in our savings bank account is actually making us poorer year over year because it is resulting in a decrease in purchasing power.

Here’s something to ponder on: Ultimately, the use of money is in its purchasing power, that it can be exchanged to buy something. Otherwise, it is just pieces of paper or a string of numbers stored in a database. What if the use of money kept in a bank account when its purchasing power actually decreases year over year?

So, why should we invest?

It should be evident from our discussion above that from a personal finance perspective, we should at least make sure that we’re not decreasing our purchasing power each over year.

So, how we do that? If our money can at least earn the same amount of interest as the rate of inflation, then our money will grow at an equal rate at which inflation is growing. This means that our purchasing power remains the same year over year.

So, how do we make our money earn a rate of interest at least equal to inflation? Through investments. We invest in assets which we feel have value and have a potential to grow in the future. All investments have some amount of risk associated with them, but there are ways to reduce/manage that risk (we’ll discuss this in the next section).

So, to recap, why should we invest?

• To not lose purchasing power over time. We aim to at least earn a rate of interest on our money equal to the inflation rate.
  
• Any return we get over and the above inflation rate will lead to an increase in purchasing power. Yayy!

Aren’t investments risky?

All investments carry risk. Typically, less risky investments give us lesser rate of return and more risky investments have a potential to provide us higher return. However, there are certain cases when this is not true.

But as I’ve illustrated above, not investing is a bigger risk, since we are almost guaranteed to become poorer over time.

There are some ways through which we can reduce/manage risk while investing:

• Diversification: Invest into different types of assets so that one asset type’s under performance doesn’t make that big an impact on our investment portfolio (portfolio simply means a basket of investments).
  
• Vary allocation to different assets depending on our financial goals: Investments should always be done keeping financial goals in mind. Examples of financial goals could be retirement, child’s education, child’s marriage, buying a house, buying a car, saving for a vacation etc.
  
  How much we allocate to a particular asset type should depend on the time horizon of the financial goal. Some asset types (like buying shares of businesses) are suited for the long term (since they can be volatile in the short term). For a goal which isn’t too far away, we can reduce risk by not having a significant allocation to such asset types.

Now that we understand what inflation is, what impact it makes on our personal finance and why is investing important, we’ll take a look at different asset types in the next blog post and attempt to understand their basic characteristics.

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