Risk is the quantifiable likelihood of loss or less-than-expected returns. Examples: currency risk, inflation risk, principal risk, country risk, economic risk, mortgage risk, liquidity risk, market risk, opportunity risk, income risk, interest rate risk, prepayment risk, credit risk, unsystematic risk, call risk, business risk, counterparty risk, purchasing-power risk, event risk
Inflation is the rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. These effects include:
- Reduction of purchasing power
- Disruptions to stock and bond markets, which may cause volatility
- Devaluation of income on interest-bearing securities
- Squeezing of the profit margins of certain types of stocks
From an investment standpoint, this means inflation is a risk to be managed and balanced against more obvious forms of risk, such as volatility and loss of principal.
Inflation Risk :-The possibility that the value of assets or income will decrease as inflation shrinks the purchasing power of a currency. Inflation causes money to decrease in value at some rate, and does so whether the money is invested or not.
Portfolio Impacts
For investors, the portfolio impacts of inflation can be discussed in terms of the long-term, overall impact, and the short-term disruptions on specific asset classes. In this respect, the impact of inflation is every bit as severe as that of a market crash - and even more devastating in the long run. Thus, investors cannot ignore inflation risk, which unlike other forms of risk, cannot be avoided simply by investing conservatively (or not at all). Even cash held in the safest vault in the world is subject to the steady erosion of purchasing power as a result of inflation
What You Can Do to Protect Your Portfolio from inflation Risk
Some critical takeaways:
- Invest in Treasury Inflation Protected Securities (or TIPS) which are the inflation-indexed bonds issued by the Govt. Treasury. These securities were first issued in 1997. The principal is adjusted to the Consumer Price Index, the commonly used measure of inflation. The coupon rate is constant, but generates a different amount of interest when multiplied by the inflation-adjusted principal, thus protecting the holder against inflation. TIPS are currently offered in 5-year, 7-year, 10-year and 20-year maturities. 30-year TIPS are no longer offered.
- When inflation is at its most extreme, no major investment is to be made,as none of the major investment asset classes were able to keep up with the rate of inflation
- Avoid the investment in bonds as effects of extreme inflation were felt most severely by bonds.
- Invest in the the longer the term of a bond, the higher the interest rate that's paid to the holder, compensating for the inflation risk of having money tied up for a long time.