The menace of Inflation

Once you get past the hurdle of saving, the next thing an investor needs to worry about is inflation. It is the erosion in purchasing power of (paper) money with the passage of time. As the purchasing power of the currency erodes, one would need more units of money to buy the same amount of a product/service in future. Let me give you an example to make it more clear:

When I was a child 25 years ago I was very fond of eating samosas (a fried indian pastry made of potatoes; no wonder I earned sourbiquets like 'mootu'). In those days samosas would cost about 50 paise (1 Indian Rupee = 100 paise). Suppose I received Rs. 20 from someone as a child and being an inspired saver I put it in my piggy bank. Today that same amount would buy me only 5 samosas instead of 40 at that time. So much rewards for the virtues of saving!!!

I am sure everyone would have their own story of how the value of money has diminshed over time. The key point for a saver is to realize that one would have to spend several times more for a good/service in future depending on their time horizon & expected inflation rate.

An inquisitive reader may inquire about the cause of inflation. While I am not an economist by training, my understanding is that inflation can occur due to various different reasons:

• Governments around the world spend more than what they earn (through taxes, etc.) to please the population and they make up for the short-fall by printing more money (given the option, who wouldn't!!). The end result is too much money chasing fewer quantity of goods and services and hence the inflation.
• We human beings always fancy the growth in value of our assets. This can happen through higher salary, high profits from a personal enterprise or through higher values of assets (especially during speculative bubbles) we own. Sometimes the money creation through such growth runs ahead of the supply of products/services we consume from that money, it again results in too much money chasing fewer quantity of goods & services and hence the inflation.
• Inflation can also occur due to supply side constraints of physical goods/human resources. Sometimes the scarcity can be due to natural causes (e.g. damage to mines due to earthquake) or it can be a contrived scarcity (e.g. restriction of oil supply by OPEC)

How can an investor/saver tackle the menace of inflation? It can be done by investing ones money in assets whose value grows faster than inflation (e.g. savings account deposit, bonds, stocks, real-estate, etc.) Based on historical results, over the long-term a savings account return will barely keep pace with inflation, bonds can provide slightly higher returns and other assets classes like stock & real-estate can provide even higher returns. Also an excellent hedge against inflation with a track record of several centuries has been gold. However I am not a big fan of investing in gold or commodities and would state the reasons when we talk about asset classes in detail.