The power of compounding – inflation is negative compounding!

Over a long period of time all things get expensive. Remember the first time your mom sent you alone to buy bread?
What was the price of bread? Re.1? Rs. 4? – well today it is Rs. 20. That is inflation. I remember my Dad topping up his Ambassador for Rs. 300 worth of petrol!

If last year you bought a soft drink for Rs. 10 and this year you paid Rs. 11 for the same drink, you have lost Re.1 to inflation. Now if you had invested this money in a bank fixed deposit which paid you 10% interest, your money has kept pace with inflation.

Instead of that if you had let it sleep in a savings bank account your Rs. 10 would have grown to Rs. 10.30 (in a best case scenario). In this case you have lost 0.70 paisa to inflation.

However if you had put this money in an equity share and it had become Rs 11.90 (well the long term averages say this is what should happen on an average). Not only have you beaten inflation but also added 90 paisa to your wealth. Now this 90 paisa will again be available for compounding.

This is the amazing thing about compounding – and inflation is negative compounding, that is all!

When you kept money in a bank fixed deposit your real return was ZERO. When you kept your money in a savings bank account your real return was MINUS 70 paisa. When you kept your money in equity shares your REAL RETURN was NINE paisa.

Since most investors are mathematically challenged they can see the 90 paisa return. However equity shares some times give you + 45% return, then follow it up with a -28% and then a +14% return – in the long run averaging say 19% (why 19% we will see later – it is an amalgam of growth rate, premium to growth rate and inflation). As is wont gyrations scare people, so they find safety in bank fixed deposit for the less lazy person. The lazy person leaves it in a savings bank account, and in most cases feels happy that he is not ‘over committed’.

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1. ##### Param

Subra,
In case your kid is writing these articles, please review them before posting…
If Rs. 10 becomes Rs. 1.19, that’s a 88.1% loss, not 19% gain. If you meant Rs. 11.90, that’s a 90 paisa gain, not 9 paisa.
Please check & tell me if I’m missing the obvious…
Regards, Param