If you save a part of your income as saving but do not invest it, the value of that money does not stay stagnant but decreases over time.
That means if you have Rs 100 today, and you keep it in your locker for 10 years. Do you think after 10 years it’ll be able to buy you the same goods/services that it can today? Absolutely not!
Why? This happens because of inflation. The value of money decreases over time.
Let’s try to break this concept of inflation and understand what it is and how it affects your savings.
What is Inflation?
Inflation is nothing but an increase in the general price level in the market.
A movie ticket used to cost Rs 100 in past, today it will cost Rs 300. The rate at which prices increases is called inflation.
Why do prices go up?
The prices of goods and services in the market are determined by the forces of demand and supply. When demand is more than supply, prices will go up. Now, this demand> supply can be due to several factors. We are not going into those details.
But one important factor is the government printing more currency notes.
The government does this to influx cash into the economy, the sudden inflow of cash raises demand and ultimately the overall prices in the economy.
If the government keeps printing currency notes recklessly the country will suffer hyperinflation. This happened in Zimbabwe in the 1990s when the government even printed a currency note of 1 Trillion!!
This did not make Zimbabwe a super-rich country, rather the economy was in a miserable state.
This is an extreme example of hyperinflation. But in every country, there is some amount of inflation. In India, it is presently around 6%.
Now let’s understand how this inflation affects your savings.
Money is a store of value: And this value decreases!
What is money? Money (or currency) is just a store of value. But how much value a unit of money stores decreases over time.
Think about it this way, you have a box and it can store 10 balls. You put 10 balls into it and keep it in the locker. You now open it after 10 years, it will still hold those 10 balls, it won’t become 20 neither will it become 5.
But let’s understand what happens in the case of money. If you have a Rs 10 note today, and you keep it in the locker for 5 years. After 5 years, would the value remain the same? Of course not.
Though it still has a face value of 10 only, the purchasing power has been reduced. The amount of goods you could buy with a 10 rupee note ten years ago is not the same anymore. That is what I mean when I say the value that currency stored has decreased over time.
This means that even if you have saved 1 Cr rupees, its value will decrease over time because its purchasing power has decreased.
If you want to preserve the purchasing power of your money, then you should invest in an asset whose interest is equal to (if not more) the inflation rate.
Let’s say the current inflation rate in India is 6%. You invest your money in bank FD, then the bank FD must give a return of at least 6% to safeguard your money against inflation.
The Rate of Inflation
The rate of inflation is not the same every year. It keeps on changing.
Say if, in any particular year, the inflation rate is 2% less, it means that if inflation was 6% last year, this year it is 4%. According to RBI guidelines, the rate of inflation can be assumed to be in the range of 2 to 6%.
How it affects your investment
We have already seen that the rate of return on any asset should be at least equal to the inflation rate to preserve the value of money.
If the rate of return on any investment is equal to the inflation rate only, it is as good as 0% ROI (rate of return),
So if you want to grow your money, you must ensure that the ROI is more than inflation.
Let’s understand this with an example.
Let’s say you invest Rs. 100 for a year and the ROI is 10%. Say, the inflation rate is 4%.
So after a year, you’ll get Rs 110. But the actual rate of return is only 6%.
So when you look at the ROI of any asset, remember to adjust the factor of inflation and get the actual rate of return.
While you invest with this approach, you effectively give your purchasing power now so that you can get more buying power in the future.