Inflation - A Destructive Reciprocal of Compounding

Albert Einstein once defined Compounding as the 8th Wonder of the World. 100% agreed. 

I would define Inflation as a 'Destructive Reciprocal of Compounding'. 

Inflation is as powerful as Compounding (assuming you understand the power of compounding) - just that it is destructive in nature, and is ignored even more than Compounding. 

If you think that you understand Inflation even today, you might just be making the biggest mistake of your financial life.

Read on...

The All Powerful Compounding

Albert Einstein once defined Compounding as the 8th Wonder of the World. I cannot agree more. Simply because Compounding seems too small to have a significant impact on your life, but as one starts to experience it, it can in fact make or break lives. Such is the impact of compounding over time, that we cannot even begin to imagine it with a mortal human mind.
[Recommended Read --> How powerful can Compound Interest Be?] 

Reciprocal of Compounding

While Compounding plays mostly in the positive sense to elevate the life of the seeker, Inflation is just the reciprocal of Compounding. Again - considered too simple, and therefore too easy to be ignored - but can devastate the financial life of the impacted seeker.

Remember that if your Corpus is not growing (compounding) at a rate faster than the inflation rate, you are actually losing money every year.

What is Inflation?

Inflation is a quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over a period of time. It is the constant rise in the general level of prices where a unit of currency buys less than it did in prior periods. Often expressed as a percentage, inflation indicates a decrease in the purchasing power of a nation’s currency.

Destructive Impact of Inflation
(Do not ignore to read, assuming it is too simple and you already know it - this is a common mistake)

Let us assume that you buy 1 Kg of Mango at Rs. 100 per Kg today.

Case 1 : 5% Inflation

With 5% inflation, after an year, you pay Rs. 105 and after 2 years, you pay Rs. 110.25 per Kg for the same mangoes. 

Can you guess how much would you pay after 40 years?

Whenever I ask this question in front of a set of audience in seminars or presentations, the general answers I get are around Rs. 250 per Kg, and extreme answers are around Rs. 500 per kg.

But here is the actual answer : It will be around Rs. 700 per Kg.

But the real answer is not too far off from the guesses !!
And that is where the precise problem actually starts. The audience usually start believing that they understand inflation, to a very large extent. And that is where it can kill you.

Case 2 : 10% Inflation

Now, let us assume that the inflation was 10% instead of 5%

With 10% inflation, after an year, you pay Rs. 110 and after 2 years, you pay Rs. 121 per Kg for the same mangoes. 

Can you guess how much would you pay after 40 years? Any guess??

Whenever I asked this in front of audience in seminars etc, the general answers are around Rs. 500 per Kg, and extreme answers are Rs. 1,000 per kg - doubling their previous answers, considering that the rate of inflation has doubled.

But here is the actual answer : It will cost you around Rs. 4,500 per Kg for the same set of mangoes !!

Is this a serious miss?

Now, this is a damn serious miss. 

If someone misses his or her financial planning by 450% (with an extreme answer of Rs. 1,000 instead of the actual Rs. 4,500) and by around 900% (with an average answer of Rs. 500 instead of the actual Rs. 4,500) - as in the above case , then you know that post financial freedom or retirement, his or her life is nothing but a financial chaos. 

The person would actually need 4.5 to 9 times the corpus he or she actually planned, or actually retired with. 

Imagine a miss of corpus by 4.5 to 9 times - and not because Inflation was not factored in the plan. Inflation was factored, but just that the destructive impact of inflation was not realised. 

Someone targeting 1 Crores at retirement might actually need anywhere between 5 to 10 Crores. Massive chaos, isn't it?

And such a financial chaos at an age of 60+ can lead to serious issues in your life, leaving you  with hardly any time to recover from the messy situation.

What is the Irony?

The irony is that not many of us are ready to sit down and focus and appreciate these finer aspects of Wealth Management. 

People usually want to know about BIG ideas, Innovative investment options, Smart entry and exist points in the market, and what not. 

So many freedom seekers ask me about the future of India's economy, how serious the current financial crisis is, and when is it going to recover. 

Well, I try not to comment on such issues, for various reasons, like there already are too many financial advisers giving gyan on this. Moreover, our economy is too complex and globally integrated to be so predictable in short run. Also, the economic volatility is actually of no concern to a long term investor and wealth creators like us - except that it is an assurance for great returns if we continue with our planned investing strategy. 

But the most important reason why I try to avoid answering such questions is that there are far more fundamental things that needs to be understood, realised, experienced and appreciated - just like Inflation or Compounding - before we try to predict the future of India's economy.

In the below sections, I am leaving you with some more information about Inflation. The more you study, the more you would appreciate it. The more you appreciate Inflation, the better you would be equipped to handle your financial life in future.

How is inflation measured?

Depending upon the selected set of goods and services used, multiple types of inflation values are calculated and tracked as inflation indexes. An index figure reflects the change in a set of associated variables over a time period and in a particular direction. 

Most commonly used inflation indexes are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI). 

Some countries, including US, do use another fairly popular index called as producer price index (PPI).

What is WPI ?

WPI stands for the Wholesale Price Index

The WPI is a popular measure of inflation, which measures and tracks the changes in the price of goods in the stages at the wholesale level (just before the retail level). While WPI items vary from one country to other, they mostly include items at the producer or wholesale level. For example, it includes cotton prices for raw cotton, cotton yarn, cotton gray goods, and cotton clothing. Although many countries and organizations use WPI, many other countries, including the U.S., use a similar variant called the producer price index (PPI).

What is CPI ?

The CPI is a measure that examines the weighted average of prices of a basket of goods and services which are of primary consumer needs. They include transportation, food and medical care. CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them based on their relative weight in the whole basket. The prices in consideration are the retail prices of each item, as available for purchase by the individual citizens. Changes in the CPI are used to assess price changes associated with the cost of living, making it one of the most frequently used statistics for identifying periods of inflation or deflation. 

How is Inflation measured in India?

In the Indian context, 5 national indices are accounted for inflation measure that include WPI and other four CPI indices. In 2013 CPI in India replaced the Whole Sale Price Index(WPI) as a main measure of inflation. It was proposed by the Urjit Patel Committee to abolish WPI and introduce CPI in India, which actually exhibits the hardships faced by the consumers due to the effect of inflation. The Reserve Bank of India (RBI) has mandated using CPI as the sole indicator of inflation for its monetary policy.

WPI Vs CPI

The Whole sale price index (WPI) measures only the cost of products and does not include the cost of services. 

Since WPI accounts for changes in general price level of goods at wholesale level, it fails to communicate actual burden borne by the end consumer. 

Inflation Rate Calculation Formula

Purchasing power = Amount of money * (cpi (this year) / cpi (last year)).

Inflation rate = cpi (this year) - cpi (last year) / cpi (last year) * 100

What are the CPI heads that define the overall CPI in India?

The CPI Index is measured across many heads. Some of the common ones are listed below. Two sub-categories of CPI in India are CPI-R (CPI Rural) and CPI-U (CPI Urban)

- Milk and Milk Products

- Oils and Fats

- Fruits and Vegetables

- Pulses

- Clothing and Footwear

- Transport

- Recreation

- Education

- Personal Care

Where can I find the official CPI figures?

It is quite interesting to look at the government (Indian) published excel files on inflation of various categories. Click here to download the latest CPI files as published by Government of India.

Global Inflation rates are also published by World Bank. Click here to view the World Bank published Inflation figures for India and every other country in the world. This gives you a holistic view of the world economy as well.

Inflation Calculation example from Government Published Figures

Once you download and open the Indian government published file as published above, it is very simple to understand and calculate the running inflation, using the formula as stated above. 

Here is one example for you.

As can be seen in the downloaded file 

CPI (Urban) in Jan 2018 for Milk and Products was : 139.6

CPI (Urban) in Jan 2019 for Milk and Products was : 141.7

% Inflation = (141.7-139.6)/141.1*100 = 1.48%

Summary

Get deeper into this monster of Inflation. 

When correctly mastered, it can lead to a well planned financial life. 

If ignored, it can devastate and destroy lives, though the realization might come too late to act.

Regards

Manoj Arora

Official Website