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The 'decompound' interest

Inflation eats into the buying power of your money, thus naturally 'decompounding' it. Understand how it works


 

According to the dictionary, income that is not spent is saving. If you don't spend 10 per cent of your income every month and just keep the cash in your cupboard, then you are saving money - no question about that. Keeping cash is a simple concept, but by itself, it does a lot of damage to your wealth. The basic reason for that is that money doesn't retain its value. Prices rise and what was worth Rs100 last year is probably worth Rs5 or 10 or even Rs20 more this year. Inflation eats away at your savings, bit by bit. We all know this, but even so, we fail to incorporate this knowledge into our savings and investments decisions. We all fail to take this into account when we put away money in supposedly safe deposits and such for long periods of time.

A lot (well, some) people understand compound interest, but most do not appreciate the decompounding effect of inflation on their money. What compound interest gives, inflation takes away. Put it another way - inflation is 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 Rs1 lakh of your money in a deposit which earns you perhaps 7 per cent a year. At the same time, prices are also generally rising at the rate of 7 per cent a year. In such a situation, your compounding returns will just about keep pace with inflation. The actual amount will increase, but what you can do with it won't. So, for example, over 10 years, your Rs1 lakh will become Rs2.16 lakh. However, at the same time, on an average the things you could buy for Rs1 lakh will also cost Rs2.16 lakh. In effect, you have not become any richer. The purchasing power of your Rs1 lakh is still 1 lakh. We all remember what things used to cost in the past - how someone earning Rs10,000 a month was comfortably middle class 30 years ago.

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However, it's very hard to believe such extrapolations into the future. 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. If today Rs2 crore sounds like the kind of money you'll want 20 years from now, then you'll actually need to have about Rs10 crore. If you work backwards from there, you'll need to save about Rs1.7 lakh a month if the returns are 8 per cent. And if the returns are 10 per cent, then you will need to save a lot less - Rs1.3 lakh a month.

Think carefully about this. People who are relying on deposit-type savings which yield very little real (above inflation rate) rates of return need to save a lot more in order to avoid old-age hardship. All of us who don't have some inherently inflation-adjusted old-age income (like rentable property) need to understand this maths and act upon it before it's too late. This may not look urgent - you can always postpone it to another day - but it's definitely more important than whatever else you are planning to do next weekend.

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