Compounding vs Inflation, make the best of both

By BankBazaar.com | June 10, 2010

Also if held for the long term, you also stand to save on the capital gains tax. Capital gains are the gains you make on your investment after deducting the inflation. As you continue to hold the investment for a long term, the compounding increases. At the same time, the rate of inflation goes up.

Besides stock market volatility, one thing that is troubling many investors is the rising inflation. It has not only put many things beyond the reach of common man but has also eroded the value of the investments. Hence every investor must be watchful of inflation. On the other hand, compounding allows the investor to beat inflation by growing the value of the investment exponentially. It builds up your investment thereby allowing it to beat inflation. So in a way, you could say inflation is negative compounding.

In order to benefit from the power of compounding and beat the inflation, you must invest your money in such a way that you get the maximum power of compounding while minimizing the effects of inflation. For this, debt instruments like bank FDs are useless. While an average bank FD gives you the return of around 6-7%, it is always lesser than the rate of inflation. As the rate of inflation goes down, so does the rate of interest on the deposits. Hence the best way to get the best of both the worlds is to invest in equities.

Why equities? This is because when the rate of inflation goes up, the companies find their expenses increasing. To recover these expenses, the companies increase the prices of their goods or services, in order to prevent any decline in profits. This in turn in reflected in higher share price. As a result, stocks have always tended to outperform the inflation. Also if held for a long period, stocks also offer you the benefit of compounding.

Assume Deepak invested Rs. 1000 in a mutual fund that offered him the return of 10%. So in the first year, the value of his investment became Rs. 1100. Now if Deepak chose not to withdraw the gain of Rs. 100, his amount of first year becomes his principle of second year. Hence again at the rate of 10%, Deepak’s investment now becomes Rs. 1210. As a result, even by making a nominal investment just once is enough to give Deepak a substantial sum, if held for a long period of time.

Also if held for the long term, you also stand to save on the capital gains tax. Capital gains are the gains you make on your investment after deducting the inflation. As you continue to hold the investment for a long term, the compounding increases. At the same time, the rate of inflation goes up. The government lets you deduct this inflation and just asks you to pay tax on the profits earned by your investment. This shows compounding is not only an inflation-beater but also a tax saver.

To benefit from compounding, begin early and investing sensibly. Sooner you begin investing, more you can beat inflation and get higher power of compounding.

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