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. 30. 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 14% (why 14% we will see in a different post – 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. Some insights I’ve gained over 20 years:
    Inflation is by design rather than by accident. Sustained inflation in goods and services occurs when Governments continually overspend (above tax collections) and resort to borrowing money from others to fund this overspending.
    This is legal, because, in a fiat currency system, only the Government stands behind a nation’s currency, and as such, only the Government has the right to print/borrow into existence more money. Ordinary citizens don’t have this right or a direct say in this process.
    One genuine reason for this overspending is Governments run a lot of social services, and when targeted properly, this benefits a lot of the underprivileged class of the society.
    Hence, when looked at this way, Inflation is the legalized taxation of your money for the privilege you get of using and benefitting from using the ‘Rupee’ as a means of transaction.

    Now, if there were no inflation, i.e. a government spent only as much as it collected in taxes, over time, this would cause a *deflation*, since, as economies grow and output more goods and services, if there is NO extra money supply, prices drop since there is more goods and services supply as compared to aggregate money supply. This would mean that, even if you left your money under the mattress as a lazy person, its purchasing power would improve over time, which would give you even more inclination to hoard it!
    This provides another reason to allow inflation rather than not. With inflation, citizens cannot hoard wealth in the form of cash for long. It will slowly erode and wither over time. Money is the lifeblood of the economy and if people start hoarding (and this is raw cash/cash equivalent I’m talking about), then it will form big clots, reduce money supply, and create even more trouble, called the deflationary spiral, where eventually all economic activity will come to a halt.
    This situation is kind of like in the movie “Bee Movie” if you’ve seen it, where, when the humans stop stealing the Bees’ honey, the Bees stop working, relying instead on their already collected honey. When this happened, the pollination stopped, causing next generation of trees and plants to fail and eventually threatened everyone’s existence!
    So….hope readers understood the REASON why inflation is a necessary evil and required at the macro level…now all go out and work your a$$ off to avoid its troubles!

  2. That was a nice explanation about inflation LuckyOye!! Is it true that the real economic activity depends on the wealthy who borrow money, take risk with capital, start businesses, employ people and pay huge taxes as corporate profits compared to ordinary people who are happy and secure with day jobs and pay comparatively less tax? But politics dictate that these rich people be portrayed as greedy and evil so as to appease the common man or poor people who are vast in numbers. Am I wrong here?

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