From an individual investor’s perspective, inflation is one of the most important indicators to understand and track. Inflation indicates an overall increase in the general price level of goods and services in a country. When we read that last year inflation was 7%, it doesn’t mean that price of every product like milk, cars, clothes, etc., increased by 7%. It means compared to the previous year on average prices of all goods and services increased by 7%.
Each one of us would have definitely experienced the impact of inflation in our lives. In 90s, our overall college education fees never used to be more than few thousand rupees, but now it’s always in lakhs and crores. We know that since our childhood, prices of almost all goods and services have jumped manyfold. Let’s take a basic example:
2005: You have Rs 100 and price of a cigarette is Rs 5. You can buy 20 cigarettes with Rs 100.
2015: You have the same Rs 100, but the price of a cigarette has increased from Rs 5 to Rs 12. Now instead of 20, you can buy only 8 cigarettes.
This example clearly shows how inflation reduces value of money. Over a period of time, the same amount of money will buy less units of the same good, thereby reducing the individual’s purchasing power. Hence it is very important to invest one’s money and grow it.
Over the last decade, average inflation in India was around 8.4%. After-tax average rate of return on fixed deposits (assuming tax @ 20%) was around 6.2%. Thus, by investing in FDs you were actually reducing the value of your money by 2.2% every year, instead of growing it.
Now that we know what inflation is, we need to understand what causes it. Inflation depends on price, which is determined by demand and supply. So if people have more money leading to more demand than supply, price increases. This is called demand pull inflation and is caused by too much money chasing too few goods. On the other hand, if supply is less compared to demand, again prices increase and cause inflation. This is called supply push inflation.
During the last decade, average annual inflation in India was around 8.4%. After tax average annual rate of return on fixed deposits (assuming tax @ 20%) was around 6.2%. Thus, by investing in FDs you were actually reducing the value of your money by approximately 2.2% every year, instead of growing it. The rate of return on savings deposit account is always less than return on fixed deposit (FD) and interest rate on bonds are comparable with returns on fixed deposits. So after accounting for inflation, any individual who invested in savings account deposit, fixed deposits or bonds actually lost money in the real sense. During the same decade, stock markets generated an after-tax average annual return of 16%! Certainly makes sense to start investing in equity and stop losing money investing in bonds and FD’s.