How does inflation affect your investment?

Suppose you have an option to either invest in a fixed deposit (currently yields about 8-9% pa) or in equity markets (have yielded average returns in the range of 12-15% over the last 10 years). Which investment avenue would you prefer? A rational risk averse investor would most likely opt for an investment in fixed deposit rather than equity markets. Investing in fixed deposit would not only provide capital protection but will also generate steady interest income for the investor.Now let us add another rider here. Assume that the inflation  rate prevailing in the economy is about 10%. Is the investor better off than before?

In order to answer this question, first one needs to understand the relationship between nominal interest rate real interest rate and inflation. Going by the classic text book explanation the relationship between these three variables is defined as follows:-

(1+Nominal Interest Rate) = (1+Real Interest Rate)*(1+Inflation)

An approximation of the above formula gives us the following relationship:-

Nominal interest rate = Real Interest Rate+ Inflation

It should be noted that the interest rate quoted on any particular investment is generally the "nominal interest rate". Hence, the interest rate quoted on your fixed deposit of 8-9% is the nominal interest rate. However, an investor should ideally be concerned about the real return on his investment as inflation typically reduces the purchasing power of any currency. Thus, any benefit gained from higher nominal interest rate (due to increased inflation) is virtually erased by the reduced purchasing power