The correct way to adjust investments for inflation

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

27 December 2009

If you wanted to have one million shillings 10 years from now, how much would you need to keep in the bank for the period? The answer depends on the interest rate that the bank will offer. Currently in Kenya, the figure is between 5 and 7 per cent, per annum in a fixed deposit account. We can therefore work safely with 6 percent.

If you deposit any amount of money and get 6 per cent per annum, it will grow by a factor of 1.06 times in the first year. In the second year, it will be 1.06 multiplied by 1.06, equals 1.124 times. Continuing this process for ten years, we find that the money will have grown 1.79 times at the end of the period.

Therefore, if you want to have one million shillings at the bank in ten years time, you should deposit about Sh558,000 today and leave it there. This is obtained by dividing one million by 1.79. However, you might find that after the end of the period, you have a little more than you expected.

The reason is that most banks pay the interest on a monthly basis. Thus you would be getting half a per cent every month. This is 6 per cent divided by 12 months of the year.

When the interest is calculated monthly, any money deposited for ten years (120 months), grows by a factor of 1.82. Thus instead of Sh558,000, you should invest Sh550,000.

There is a small problem, however: due to inflation, whatever you can buy for one million shillings today will cost you more in ten years time. Latest figures indicate that our underlying inflation is about 6 per cent – same rate as what the banks are likely to pay you. So does this mean that you will just have as much money as you started with? Let’s find out.

In the first year, your money grows by a factor of 1.06; but it also loses 6 percent. This is a loss factor of 0.94. Therefore, the net effect is a loss by a factor of 0.9964. In other words, if you are paid 6 per cent interest at a time when the inflation rate is also 6 per cent, you end up worse than you were before!

This brings out a common mistake that people make when adjusting their investment returns for inflation. A person expecting, say 10 percent per annum will simply subtract the rate of inflation (6 per cent at the moment) and conclude that he is getting a net of 4 per cent.

The reality is that he actually getting less than 4 per cent.. The investment increases his money by a factor of 1.1 while inflation reduces it by a factor of 0.94. The net result is a growth of only 3.4 per cent (1.1 multiplied by 0.94).

The difference might look small for a one year investment, but it is quite large over ten years. For one million shillings, the incorrect method yields that the investment will gain SH480,000 while the correct calculation gives Sh397,000 – sh87,000 less.