The more I write and the more I communicate with people new to finance, the more I realise the need to ‘de-jargonise’. However I am also convinced that if you need to use your money, it is necessary for you to learn simple words like inflation.
With Wikipedia, Investopedia and Google around, I do not want to get into ‘what is inflation’….suffice it to say it is NEGATIVE compounding and can harm your portfolio.
If you have to make your money work hard for you, your PORTFOLIO has to give you REAL returns. REAL returns means the returns that you get AFTER TAXES AND after reducing inflation.
Let us take an explanation of a ONE year return (it holds true for the longer term also).
Suppose you keep a bank fixed deposit of Rs. 10,00,000 at a 10% p.a. return, your calculation would look like this:
Opening balance 10,00,000
Interest income: 100,000
Taxation (assuming 30%) 30,000
Post tax return 70,000
Closing value 10,70,000
Inflation (assuming 8%) 80,000
Closing value of the amount 9,90,000
So thanks to tax and inflation the portfolio is down by 1% over a period of ONE year.
Over a 30-40-50 years this can ruin your wealth.
So it is necessary that the portfolio return overall be POSITIVE. Fairly obviously savings bank accounts, bank FD, Lic endowment policies …can ONLY return NEGATIVE returns.
To make up for this…you need to invest in equities (and enough quantity) so that your OVERALL return is in the POSITIVE areas….
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