this article appeared in money mantra….as a lead story on inflation.

Inflation is perhaps one of the least understood risks in investing. Understanding the power of small numbers is not easy. That is the reason why people find it difficult to understand the impact of compounding too – after all inflation is just negative compounding. Let us take an example. If you met a financial planner in 1968 and told him your monthly expenses were Rs. 700 per month, the figure looked reasonable. If the financial planner had asked the client “How much do you think will inflation be?” the client would have said say 12% – the prevailing rate then.

The planner would have quickly used a calculator and said – “Well Sir, your monthly expenses in 2009 would be Rs. 72,952 per month in retirement.”

A good chance that the client would have laughed at this – because his starting salary in 1968 would have been Rs. 950 as a freshly qualified Chartered Accountant! However if he had provided even for inflation at 9% per annum, the planner would have arrived at a figure of Rs. 16,424. See how much difference even a 3% change in inflation rate can do to your expenses. This is exactly the opposite of compounding – in other words if you had invested just Rs. 700 (in 1968) in an asset class which gave you 12% yearly compounded returns, your money would have grown to Rs. 72,952 in the year 2009.

What exactly is inflation?

It is a capitalist concept of the currency being able to buy less on a year to year basis caused by the erosion of purchasing power of the currency. It is a world wide sustained trend of increasing prices from one year to the next year. As seen earlier the rate of inflation is just as important – because the impact on the common man is quite harsh even if it is a small number but for a long period! Inflation is particularly harsh on people who have low income as well as those who have a fixed income. If a person has a fixed income – like interest from a bank fixed deposit – or a pension which does not adjust for inflation, they get hurt very badly. The only way they can provide for a hedge against inflation is by investing in ‘growth but variable returns’ assets like direct equity, equity mutual funds, or real estate.

You must have surely experienced inflation – remember the first time you went with your parent to a petrol pump? Or when you went to buy a loaf of bread? Or when your grandmother tells you that her parents bought her gold worth Rs. 1000 for her marriage? If you compare the prices of 1970 to the prices of 2009, the impact is that of inflation. I remember buying bread in 1970 for Rs. 0.70 and now I pay Rs. 22 for a loaf!

Over a shorter period too – if you paid Rs. 30 for a cup of coffee in 2008 and you now pay Rs. 33 for a cup, inflation is 10% for the previous year. Of course not all items inflate at the same rate. Branded goods inflate at a higher rate than un-branded goods, and vegetables may inflate at a rate less than services.  Inflation is about money growth, and it is an indicator of too much money chasing too few products.   This is the reason why, investors should try to buy investment products with returns that are equal to or greater than inflation. For example, if a particular share returned 8% and inflation was 7%, then the actual return (real return) would be 1% (8%-7%). Though this sounds good in theory it is quite normal to see ‘savers’  talk about the golden times when they got 21% return on company fixed deposits. They forget that those were times when inflation too was at 17-18%! Effective interest then was also 21-18 = 3%. This is the number that savers and investors should be chasing, not just nominal interest.