What compound interest gives, inflation takes away. Put it another way- inflation is the effectively the reverse, it's like decompound interest.
Since each year's inflation occurs on top of the previous year's inflation, it means that the effect is just like that of compound interest. Consider a situation where you invest Rs 1 lakh of your money in a deposit which earns you 8 per cent a year. At the same time, the prices are also generally rising at the rate of 8 per cent a year. In such a situation, your compounding returns will just about keep pace with the inflation.
The actual amount will increase, but what you can do with it won't increase in line. So, for example, over ten years your R1 lakh will become R2.16 lakh. However, at the same time, on an average the things you could have bought for R1 lakh will also cost R2.16 lakh. In effect, you have not become any richer. The purchasing power of your R1 lakh what it used to be ten years ago. The rise in the amount of money you hold is just an illusion and is completely negated by a corresponding rise in prices.
But inflation may not be so kind as to stay at the level of the interest you are earning. What if it's more? And what if this goes on for a very long time. Suppose your returns are 8 per cent but inflation stays at 10 per cent and twenty years go by?
Your investment would grow to R4.66 lakh but things that used to cost R1 lakh would now cost R6.72 lakh. Now, the purchasing power of your R1 lakh is just R69,000. Your investment has actually made you poorer! This is not a theoretical example- it actually happens to millions in India. In our country, over the past thirty to forty years, the inflation rate has been either the same or a little bit higher than many of the deposits that are available. Unfortunately, far too many people think of the two problems as unrelated.
The common problem is the inability to account for inflation. People think in nominal terms and the future impact of inflation is awfully hard to internalise. The real solution to this is that we should become a low-inflation economy but since that's clearly not on the agenda, savers should always adjust for inflation mentally.
If R1 crore sounds like the kind of money you'll want twenty years from now then you'll actually need to have about R4 crore. If you work backwards from there, you'll need to save about R68,000 a month if the returns are 8 per cent. By the way, if you don't already use it then google 'rule of 72', which makes quick and rough calculations of this sort easier.
That's a depressingly large amount, but there it is, there's no escape from the arithmetic. What that actually tells you is that over long periods of time, you need a form of investment that's inflation adjusted. That equity is risky, is drummed into all investors.
However, it takes just a little thinking to figure out that inflation is riskier. And to match inflation, and to get real returns on top of that, you have to latch on to something that goes up with inflation anyway. This is not difficult because the value of goods, services and assets in the economy is inherently inflation-linked. And so risky or not, equity and equity-linked investments are the only game in town to protect yourself from inflation.
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