Understand Investment Risks: The Inflation Risk

The investment risk is a possibility of an investment bringing a result other than you anticipated. In this article, we will discuss one common type of investment risk that is typically undermined by retails investors - the inflation risk.

You can also gain a return less than you expected (for example you could have expected a return on an investment of 5% but only got 2%) and still consider this as a risk or loss. It is important to realize that every investment entails some risk. The risk can be a systemic risk (typically unavoidable - such as inflation risk) or non-systemic risk (typically avoidable, such as company-specific risks). Investors lose money in investments due to a lack of understanding of the risks and poor risk-management strategies.

The inflation risk also known as the purchasing power risk is a general increase in prices leading to the fall in the purchasing value of money. It refers to the risk that inflation will undermine the performance of an investment. This risk is tied to the consumer price index which reflects inflation.

Let’s assume that in 1967 you deposited $1,000 into a savings account while the fixed interest rate was 5%. If you kept this money in the bank account until the end of 1985, there would be $2,526.95 in the account. This may sound profitable to you. However, during this time period, the value of the dollar fell to $0.31 as compared to 1967, and therefore the purchasing power of the original amount of $2,526 was only $783.35. Because you underestimated the impact of inflation you lost some of the purchasing power by $216.65 compared to 1967.

On average, over the past 3 decades, the cumulative rate of inflation is nearly 3% every year or ~30% every decade. In other words, if a pair of shoes cost $100 in 1990, the same pair of shoes will cost $197 in 2020.

Bonds are an investment that is most vulnerable to inflationary risk, due to their fixed interest rate and long duration of investments. In fact, inflation can destroy the net worth of a bond investor. And far too often, once a bond investor notices the problem with their investment, it is too late.

Managing risk is possible and needs a strategic approach. First understand different types of risks. Knowledge is the key. Then implement risk-limiting strategies such as diversification and asset allocation. And regardless of the risk type, using appropriate position size, predefining your risk tolerance, and cutting unreasonable losses using a stop-loss order is critical.

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