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What if inflation was a Game? Or it is already?
Read along for the next 4 minutes and you shall be presented with a slightly different perspective on inflation.
Inflation is a game which is constantly being played by the market forces around you automatically whether you wish to play or not!
Last year that vegetable was costing 100/KG, this year it is costing 110/KG.
Last year your favourite bike was costing 1,00,000 however now it is costing 1,05,000
Last year your dream holiday prices was 2,00,000 however now it is 2,25,000
List goes on, but you understand the theme that we are trying to put it out here.
But How is it a game you ask? Well it is a Tom and Jerry Game as we call it.
Take the following example of Mr. X and his finances!
Total Income - Rs. 10,00,000
Total Expense - Rs. 6,00,000
Total Savings - Rs. 4,00,000
Now assuming the inflation for the next year is 10% while his income increases by just 6%.
Therefore the figures for Mr. X's Finances for the next year shall be as follows:
Total Income - Rs. 10,60,000
Total Expense - Rs. 6,60,000
Total Savings - Rs. 4,00,000
Now there are two important observations here:
a) While the % increase in income (i.e. 6%) was lesser than the % increase in expenses (10%), still Mr. X was able to save the same amount i.e. Rs. 4,00,000.
This is called the Base Effect. The base for income was higher than the base for expenses and therefore the savings amount is same.
Now we shall simplify the concept of base effect as well with two examples.
Consider the example of a billionare here Eg. Mukesh Ambani.
He might put his entire networth in a savings account and not do anything at all, still the earnings from savings account will far outweigh his expenses.
However a poor labourer feels the pinch of each percentage point of inflation because with his insignificant earnings, he is not able to fulfil the needs of his family.
Inflation is therefore a boon for the rich and a curse for the poor because it redistributes the wealth from the poor to the rich!
Does it remind you of the Covid times when inflation skyrocketed and there was no income for the poor? While the rich had their assets working for them through debt/equity/real estate.
This is also one of the key learnings of the book Rich Dad Poor Dad by Robert Kiyosaki
b) While the total savings in both the years was same i.e. Rs. 4,00,000 however the value of Rs. 4 Lakh before 1 year and value of Rs. 4 Lakh today are different. This is because of the element of inflation or Time Value of Money.
With the same Rs. 4 Lakh, you shall be able to purchase lesser quantity than you could purchase a year before.
To purchase a similar quantity, his income should have been increased by the rate of inflation 10% i.e. Rs. 4,40,000
So ultimately Mr. X is poorer by Rs. 40,000 for that particular year.
This is called the Money Erosion effect.
"The value of the money reduces with each passing year, if the same has not been compounded with the pace of inflation."
Sounds like a game no?
It feels like inflation is saying that i am going to erode the value of your hard earned money whether you like it or not. It is in your hands whether you can beat me or get beaten by me (You are forced to play with him whether you like it or not).
Keep the Money in Cash - Inflation Wins, Mr. X Loses
Keep the Money in FD/Debt Instruments - Earn returns similar to Inflation
Keep the Money in Equities (Long Term) - Mr. X Wins, Inflation Loses
Keep the Money in Gold/Real Estate - Slightly better returns than inflation
Ok now we understand that inflation is for real so we might look at the cause and effects of inflation!
Well the cause for inflation are well known.
- Demand/Supply Game - Higher the demand, higher the price and Vice Versa
Higher the supply, lower the price and Vice Versa - Money Supply in the economy - Higher the supply of money, higher the inflation and vice versa
- Economic Conditions
- Government Policies
- Behavioural Factors and list goes on
Ok and what are the Effects of inflation
- Reduced Purchasing Power - Your Money buys lesser of the quantity that you could have purchased earlier.
- Increase in Borrowing Costs - With increase in Inflation, the central bank increases interest rates and therefore borrowing costs increase.
- Economic Distortions - Any nation that goes down economically generally has two primary reasons:
a) High Inflation
b) Unemployment - Economic Policy Changes and so on
Ok now we understand the Cause & Effects of Inflation and the rules of the game as well.
How should we play so that we beat inflation more often than not?
While we cannot control or opt out of the inflation game, we can employ strategies to navigate its impact effectively.
Well firstly by understanding that inflation is for real. This is here to stay.
Once that is out of the way, the below points could be some of the First Principles based on which we can plan our financial journey.
a) Budget | Save | Invest - Keep a broad track of your income and expenses. Once you do this, you can plan your savings and hence your investments.
Anybody can follow the following two rules for this:
- Rule 1: Save atleast 30% of your income. Higher the better.
- Rule 2: 100 - Your age. eg. if your age is 30, you should invest atleast 70% in equities (100-30).
Therefore if you are someone who is earning Rs. 50,000 a month salary and your age is 30 than you should be saving atleast 30% of Rs. 50,000 i.e. Rs. 15,000 and investing atleast 70% of Rs. 15,000 in equities i.e. Rs. 10,500 every month.
b) Build multiple sources of Income - Being over dependent on one source of income may come to haunt you if that one stream stops. So even if you are a salaried professional - build alternative portfolio of investments slowly and steadily, do some side gigs etc.
c) Asset Allocation: Now that we understand that we need to beat inflation at their game, we need to understand ourselves. Yes Personal finance is personal for a reason.
Understand Yourselves
Understand the Risk you can take
Understand the Return Expectations
Understand the Asset Class you wish to invest
Finally Allocate your investment in a manner that can provide you inflation adjusted returns.
We have written in depth about this on TaxGuru Forum. The link for the same is here.
d) Maintain a Long Term perspective - Understand that Inflation is playing a life long game against you.
Its like a test match. You win some sessions of the match, Inflation wins some session of the match. However the ultimate win is decided by who wins more sessions.
Your income or portfolio may not be able to beat inflation in all the years, however it is important that they beat them more often than not.
I hope this helps you builds a perspective on your financial journey.
What is your take on the matter? Do let me know your feedback through WhatsApp here.
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The writer is a passionate student of finance and markets.
CA Parth Shah
You can read all my previous blogs here:
Thanks for reading!
Until next time, keep learning.
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