Introduction to equity investing

April 5, 2014May 6, 2017 calminvestor 7 Comments Inflation, infographic, Investing Essentials

At a glance

‘Inflation’ is the persistent rise in price of goods and services

It is a ‘normal’ and ever-present economic phenomenon that results in loss of purchasing power

Rs 100 in India in 2014 would only be able to buy 40% of goods it would have been able to buy in 2004, losing close to 60% value in ten years

We therefore need to invest to counter the corrosive effect of inflation on our savings

“Americans are getting stronger. Twenty years ago, it took two people to carry ten dollars’ worth of groceries. Today, a five-year old can do it” – Henry Youngman

If money is a generally accepted medium of exchange because it was too inconvenient to lug your goods (farm produce, animals, furniture…) looking to exchange them for things we need, why then does the value of money¹ vary with time? If I could get a bag of potatoes in exchange for a goat in 1850, it’s unlikely I’d be willing to hand over an entire herd for the same quantity of potatoes in 2014.

Would it not be simpler if an item cost the same today as it did two decades ago?

Simply put, inflation is the persistent rise in the average price of goods and services.

The classical rationale for inflation is that as governments print money, larger amounts of it chase the same quantity of goods leading to increase in prices. In reality², in addition to increasing money supply, a combination of rising demand, pricing power exercised by monopolists, supply shocks are some of the reasons why prices rise. Another popular measure of inflation is the Wholesale Price Index (WPI) but is less relevant to the retail consumer in the calculating real purchasing power.

Chart shows consumer price inflation (CPI) in India over the last nearly three decades

Barring 1999 following a record inflation of 15%, inflation in India has been upwards of 3% and at a median of 8.72% over the last 28 years. This translates to an item that cost ₹1.00 at the end of 1985, costing ₹8.63 at the beginning of 2014, a 690% increase!

Another way to think of the impact of inflation is how the value of currency stuffed in a mattress will change over time due to inflation.

Chart shows ₹100 over a 10 year period losing over half its ‘real’ value (in terms of what it can buy)

Bear in mind that this rate doesn’t apply to every good equally and you have to allow for improvement in quality of certain items, for example a car tire bought in 2014 is likely to last several times more than one in 1985 so the cost / km might actually be less in 2014 even though the tire costs significantly more. But that principle is only selectively applicable and it’s safe to say that the value of money decays at an alarming rate and is likely to do so into our foreseeable future.

In summary, we invest, at a minimum, to protect the real value of our money. The true objective is however to do more than retain the value but to generate real wealth.

References (links to external websites):

¹ Inflation Basics (Investopedia)

² What actually causes inflation (Forbes)

³ The importance of the Consumer Price Index (CPI) (LiveMint)