Inflation risk is the risk that an investment will not grow fast enough to offset the lost purchasing power of your invested cash.
Inflation is the rising cost of goods and services that makes up what we commonly call the cost of living.
A broad but manageable increase in inflation over the years is considered a sign that the economy is in good shape. It means incomes are rising as well, which leads to spending and emboldens producers to raise prices accordingly.
Inflation can get out of hand, however. That’s why the U.S. Federal Reserve watches prices carefully, hoping to steer the economy toward growth without risking too much inflation. It’s also why we use investments in stocks, bonds and other assets to increase our unspent cash.
Inflation risk is just one factor among many in evaluating an investment, but it can be an important one.
For instance, if a bond pays a return that is at or near the current inflation rate, you have protected the value of your cash but you have not increased your wealth. That might be a reasonable result if other risks you take on the bond are very low, such as the risk the bond might default.
Comparatively, a stock that that fails to keep up with inflation is perhaps a poor investment. Most investors buy stocks precisely because historically they grow faster than the inflation rate.
Inflation risk is just one of several risks that are inherent in investing. For instance, a company issuing stock could declare bankruptcy. A bond-issuing company or government might default on the bond.
There are also a variety of risks that come from simple human reactions to investing. Any investment can be sold too early or too late, for instance. It’s far too easy to allow our emotions to take over or to let our perception of an investment become more important than facts.
Still another risk is failing to invest at all. Far too often, young investors put their hard-earned cash into retirement accounts and then sit on it, waiting for the right time to invest.
Money should grow and compounds over decades. When you’re 70, it won’t matter if you bought your first stock at age 22 or 23. In fact, you should be investing steadily with each paycheck regardless of the position of the stock market.
Steady investing of your cash means you are buying away inflation risk by being invested in the first place. If you’re worried about selecting the “right” investments, then use a broad stock mutual fund instead.
For most people, the most cost-effective way is to own an index fund that tracks either the S&P 500 or the whole stock market.
Inflation risk is diminished simply by owning effective inflation-beating investments, mostly stock investments. Diversification reduces the emotional risk of selling or buying at inopportune times.
As you invest over the years, that value of your cash should greatly exceed inflation thanks to the magic of compounding. The trick is to start early, invest consistently and to stick to a long-term plan.