Lot of people don’t understand how inflation eats into their money. They ask “Why don’t I keep it in a safe in my house? Or hide it cleverly under some tiles or a book I scrape out the inside? It will be very safe right?”

It will be very safe from the robbers who are going to break into your house. But it is not safe from the robber hiding inside your house – inflation. Locked doors or clever book safes don’t stop it.

Every year he takes out some of your money never to be seen again. To better understand it think of what a rupee note denotes. The paper note doesn’t have any value by itself. It’s what you could buy with it that gives that paper the value. If you could buy a pen for Rs.10, that’s what is the value of the 10 Rupee note.

Lets go back to 1984 for a minute. Imagine you living in the 80s and you having Rs. 1,00,000 in cash with you. What could you buy with Rs. 1 lakh then? You could buy a piece (more than 1000 Sq.Ft.) of land in a great location inside the city limits.

Now back to 2014, imagine you have the same Rs.1,00,000 cash with you and I ask you to buy the same land. How much of the land will you be able to buy (assuming the seller is ready to divide it into as small a piece as possible)? It would be a miracle if you could even buy 1 Square Feet of the land with the Rs.1 lakh.

Now what happened? You were having the same Rs.1,00,000 in both the examples. You were able to buy more than 1000 square feet of land in a great location inside the city. But if you had instead kept the 1 lakh as cash in your safe for 30 years and now you took it out to buy land, you would be able to buy less than 1 square feet of the same land. Since no one can/will sell 1 square feet of land we have to go miles outside the city limit and to buy a similar priced land.

This example is applicable if you wanted to buy anything – be it gold, food, petrol, dresses, etc. Now imagine you doing the same mistake of keeping Rs. 1 lakh in a safe and taking it out after 30 years to buy something. It would be close to impossible to buy whatever you want to buy.

This is what inflation does to your money in hand. Remember this, the next time you have excess money lying unused in your bank account.

In all the previous posts I have been saying to invest in the long-term for equity. Ask any good financial planner, they will also say you should invest in the long-term. So you can ask how long is long-term? 1 year? 5 years? 10 years? 30 years?

Actually, people have analysed past data from sensex from 33 years and have found out that holding your investment for 7 years yields the maximum return irrespective of the time you have started investing (in a bull/bear market).

They defined targets with 8% (average inflation rate), 10%, 12%, 15%, 16.2% (33 years market average return). Staying invested for minimum 7 years is all it takes to hit these targets.

Does this mean you take out all your money after 7 years? No. Of course not. The longer you stay invested, the better your returns are. The famous example always given is “if you bought 100 shares of Wipro for Rs. 100 each (Rs. 10,000 investment) in 1980s, it would’ve grown to more than Rs.535 crores by the year 2014.” Phenomenal growth by just staying invested for 34 years.

Remember that when you think you want to make money in short-term.

 

Yesterday we saw the various options where you can invest your money (and also save tax). But you should make sure you shouldn’t put all your money in a single place. The risks are either you wouldn’t earn enough returns on it or you may lose all your money. That is the relationship between risk and reward.

More risk = More reward.
Low risk = Low reward.

The best solution to this, is to split your investment into various asset classes, so that you minimize risk and also get better reward.

Let me show you some examples of why putting all your money in one asset class is bad.

Investment Cycle

For quite a few years, everyone were investing in Gold, thinking it would always increase in value. But this year, after reaching new highs it began to drop quickly. Everyone who invested when the value of gold was reaching new highs, are now at a loss. And it would take many years for them to get profits.

This doesn’t apply just to Gold. There were many who invested in the equity market because the market was reaching new highs in 2008. But those put in all their money then, still are yet to recover and would take a few more years to become profitable.

So did people who had all their money in fixed deposit in 2003-2004, they didn’t participate in the bull run of the equity market. Their returns would have been very low than those who invested in shares.

What does this teach us? Every asset class follows a cycle. When one particular asset class is bullish, others wouldn’t be giving you any returns and sometimes would even be negative.

The best way to protect against this is to invest in all types of asset classes. But now is the question of how much to put in each class.

What percentage, in what?

It isn’t easy to say how much one should put in equity vs debt vs gold vs real estate without understanding your financial profile and risk appetite. But there is a simple rule of thumb that should work out, especially to find out how much one can invest in equity.

Take your age and subtract it from 100. That is the percentage of your investment that can be in equity. So if you are 25 years old, you can have 75% of your investment in equity market. “But, but, you said Equity was risky. I don’t want risk”. Yes. equity is risky, but if you keep invested in the long term, you minimize all risks.

Since you are just 25, you still have a long way to go and can thus put in more money a risky investment. The remaining 25% can be split into fixed deposits, gold, etc. By investing a majority in shares you would get a better return than just fixed deposits. When you grow older, you should slowly shift your investments from equity to debt which is more safer (but also rewards less).

TL;DR: Don’t put all your eggs in one basket. Split your money into different asset classes. Younger you are, the more risk you can take.

If you had asked this question sometime in your life, don’t worry – it isn’t a stupid question. In fact it can be used to easily explain one complex term “Inflation”.

Lets assume you and your friend got into a job and get the same salary (say Rs. 25000 per month) and you both coincidentally have the same expenses (just for calculation) and both have a surplus of Rs. 10,000 per month. Just for easier calculation, I am assuming you both can only get a surplus of Rs. 10,000 per month even though you might have got numerous pay raises and there are no emergencies in the family.

Lets compare both your situation based on what you do with this surplus money. Your friend (lets call him “Dumb Dinesh”) doesn’t trust banks or other financial institutions and decides to withdraw all the money and store it under his mattress. Can be taken literally or also figuratively where he keeps all his money in a safe in his house. What are the risks?

Immediate risks: it (the entire safe) could be stolen by robbers when he is on a vacation, his house could catch a fire (or flood) and everything is destroyed, etc. These are easy to imagine, but there is another form of risk that you can’t see the effects immediately. That is inflation.

Inflation is the general rise in prices of goods and services in an economy over a period of time.

To explain it easily, lets say a dinner for two in a nice restaurant costs Rs. 1000 today. 10 years in the future the same dinner in the same restaurant would cost Rs. 2000. Which means the cost of the product/service has increased by 2 times over 10 years.

Now imagine “Dumb Dinesh” keeps all his money Rs. 10000 per month for 30 years he is in a job in the safe (assuming it isn’t stolen or caught in a fire) he would have a total of Rs. 36 lakh. With Rs.36 lakhs say one could buy a nice premium car (Audi? Benz?) today. But 30 years later, with the same Rs. 36 lakhs, he could only be able to buy a Hyundai Santro.

That is what inflation does, it erodes the value of your money slowly and at the end of 30-40 years, when you got no source of income, it becomes very difficult to lead the same comfortable life you live today with the same money.

Lets now take your case, where you our reader, understanding how inflation works, decided to invest your money smartly and safely. Even if you invested Rs.36 lakh as a lump sum amount today in a very modest interest rate of 8%, and doing a simple interest calculation for 30 years would yield Rs. 86.4 lakhs. That is more than twice of what you invested.

But remember, money always grows exponentially because of the effects of compounding as we have seen earlier. Also investing regularly and compounding the returns, you can get returns in terms of crores. Compare the few lakhs “Dumb Dinesh” vs your investment which has grown to crores.

Easiest way to beat inflation is to make sure you invest your money in products which yield higher rates than the annual inflation rate. The government regularly publishes the inflation rates as it fluctuates over a period of time. Eg: if the average inflation is around 6-7%, then if you invested in products earning anything more than 8%, you are safe and your investment is protected against inflation.

Also remember, you don’t withdraw your entire money in your portfolio on the day you retire. You take it out monthly, to meet your expenses. And while you have taken out a few lakhs for your monthly expenses, the remaining crores of rupees are sitting safely in the bank/investment products still earning you more money.

In the end you turn out to be a winner by a HUGE margin than your friend who stored his money under the mattress. Tomorrow we will look at the various types of investments that are easily available to Indians and their rates of returns.