Mutual Funds Day 7: Inflation
We hear people say Inflation is the rise of prices of products & services. Even though we feel the prices are rising, the technical definition of Inflation is the “Erosion of Purchasing Power”.
If your money bought 100 units of a commodity this year, it may buy only 95 units next year. Our purchasing power reduces with time. Since we hold the same amount of cash in hand, but lower units of commodity are getting purchased — we say the product prices are rising.
You can compare it with an old pair of Jeans. You would say the “Jeans are not fitting” when the reality is that you have become bigger, you blame the Jeans for becoming smaller.
“Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.” ― Sam Ewing
Inflation is taxation without legislation. — Milton Friedman
Let us assume a farmer lends 10 hens to another farmer for a year. Each hen costs Rs1000. The condition is that the borrower has to return the 10 hens + give the money to buy 1 additional hen. The borrower has to give the original 10 hens back and also pay Rs1000 to the lender. i.e. 10% interest.
After a year, if the cost of the hen goes to Rs1100, the lender will not be able to buy a new hen even though the borrower pays Rs1000 as interest. This variance is called inflation.
In India, the inflation band is 4 to 6%. If you hold savings as cash, that means you are losing out 4–6% value per year. This puts us into a dilemma — whether to spend more today or find investment opportunities higher than 6% interest.
Inflation affects the cost of borrowing also. Suppose you took a personal loan with a 10% interest rate. Inflation means you are paying 14 to 16% as actuals.
Inflation is the hidden tax that all of us pay. Economists believe that a developing country will have higher inflation due to its fiscal policies. Inflation affects the poor and the rich in opposite ways. The Poor are pushed further into poverty as their income will not rise as fast as the inflation slab.
Whereas Rich gets a higher yield from his assets. eg: They can ask the tenant to pay a higher rental income.
Inflation has a bearing on the Investment decisions you make. To stay ahead you need to choose financial products that have a higher ROI than Inflation. Holding physical cash is a recipe for disaster.
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