To become a successful investor, it is important to understand the concept of inflation since it is the difference between savings and investments. Just like animals save and store food and water for the winter, human beings save money to provide for a safety cushion for an uncertain future, something that gives us mental peace.
While saving money from our earnings helps us counter an uncertain future, investments help us utilize such savings to generate returns in a way that we do not have to work to earn money, thereby leading to financial independence and enhancing our capability to face problems in the future. The difficulty faced by a common man in understanding investment stems from the fact that he is unable to differentiate between the terms “money” and “wealth”.
“Money” is anything that is a medium of exchange that serves as a unit of account to help you undertake a transaction and helps you store and transfer value from one generation to the next. Consequently, the leading world currencies such as ₹, $, £, and ¥ are all considered money.
In the ancient ages, mudras (money) were made of either gold or silver as they are precious and valuable metals, and therefore, humans got products/ services equivalent to the value of mudra spent. Since the supply of gold and silver was limited, while people’s income increased with economic development, its actual value remained dependent on the supply of mudra. Countries like Spain, Portugal, Britain, and France ruled the world, collected gold and silver from the ruling colonies, and brought it to Europe, thereby introducing Europe to the concept of inflation (since the level of mudra is directly proportional to the level of inflation)
The progress of mankind and the growth in business in the 20th century was interrupted by the two World Wars, post which undertaking transactions using gold and silver was deemed to be impractical. The Bretton Woods Treaty mandated all countries to use US Dollars to carry out business. The promise made by the USA to give 1 ounce of gold in exchange for every $35 to all countries meant that owning dollars meant owning gold – something called “Gold Standard” or “Representative Money”. The slow rise of inflation till representative money existed increased tremendously with wars and famine.
In 1971, American President Richard Nixon ordered the stoppage of the policy of “Representative Money” by stating that the dollar will not be converted to gold but will still work as a Legal Tender, thus making it a “Fiat currency” (currency which does not have its own value as compared to gold and silver)
The passage of time creates some amazing yet amusing scenarios. For instance. the old INR 1 silver coins approved by the Indian government which is equivalent to at least INR 1,000 today. Compare that with the fiat currency in vogue today which can be printed at will for economic development (leading to inflation) or maybe derecognized as legal tender (refer to demonetization of INR 500 and INR 1,000 notes in 2016 by the Indian government) making it cease to have any value whatsoever. This is why fiat currency has no intrinsic value and why investing in assets like precious metals and real estate triumphs over saving fiat currency.
The difference between savings and investments brought about by inflation is on account of something referred to as “time value of money”. The time value of money and its impact on wealth can be understood by attempting to make a choice between the options in the below scenarios:
- Receiving INR 500 in 2020 versus. receiving INR 500 in 2000
- Receiving 100gm gold in 2020 v. receiving 100gm gold in 2,000
While one would be eager to choose option 2 in the first scenario because “A bird in the hand worth two in the bush”, one would be indifferent between the 2 options in the second. This is because while the purchasing power of INR 500 in the year 2000 was higher than the purchasing power of INR 500 today, the purchasing power of 100gm gold does not decrease with time. This is because while the currency has a diminishing intrinsic value, gold does not. Due to this, the accumulation of gold leads to wealth maximization whereas the accumulation of currency does not. The change in intrinsic value due to the passage of time is called “time value of money”.
It is easy then to see why the richest persons globally, are owners of equity in enterprises, gold and real estate for the intrinsic value of each of these assets increases with time and it is easy to understand why these asset classes are tools of wealth maximization whereas currency is not. There are many real-life lessons to be learned from theoretical concepts and this article is but the first step to become a better, successful investor.