Inflation Risk

Inflation erodes purchasing power. An investment that pays a fixed amount in money terms becomes less valuable in real terms when prices rise.

For example, a bond paying a fixed 3% a year delivers a real return of about −2% in a year when inflation is 5%. The investor receives the promised interest but can buy less with their total wealth than before.

Inflation risk is highest for investments with fixed payments over long periods, such as long-term bonds, fixed annuities and cash held for many years. It is also a major concern for retirees whose income does not rise with prices.

Some investments offer protection. Inflation-linked bonds adjust their payments in line with an inflation index. Shares, property and some commodities have tended to keep pace with or outgrow inflation over long periods, although not reliably in every period.

Inflation risk is often underestimated because its effects are gradual. Even moderate inflation of 3% a year roughly halves purchasing power over about 23 years. For long-term goals, planning in real terms, after inflation, gives a more accurate picture.