Risk Basics: Inflation Risk

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Inflation RiskThere is always inflation concerns tossed around by doomsayers every year.  What they never tell you is inflation risk isn’t about the existence of inflation.  The worry should be about excessive inflation or hyperinflation and the opposite, deflation.  A healthy amount of inflation is a good thing.  That said, there are ways to protect your money when inflation risk rises.

What Is Inflation Risk?

Inflation risk can be felt on the consumer side, with the loss of purchasing power.  This falls under the time value of money and the concept that a dollar today is worth more than a dollar tomorrow.

We also see the same risk with our investments.  Inflation causes the value of money to decrease over time whether it’s invested or not.  The inflation risk exists when we have money sitting in cash or other assets not linked to inflation.  In the process, the cash value decreases due to inflation or more likely, excessive inflation.

Real Return And Our Portfolio

So why is this important?  Inflation affects our spending habits and investments.  An average inflation rate of 3% may be hard to spot in the price of milk during the year.  Taken over 30 years, the difference is obvious.

This is why our investment choices in our retirement account is so important.  If all our investments average a return equal to that 3%, we are not growing our money.  We’re just keeping up with inflation and have no real return.

Real return is just our investment return minus inflation.  If our portfolio returned 8% this year and inflation was 3%, our real return would have been 5%.  Of course, the problem occurs when the inflation rate is outperforming our investment returns.

Pensions and social security have built-in inflation protection.  Unfortunately, pensions are a vanishing retirement plan and social security falls short in the reliability department.  What we are left with is the ever popular 401k, the less often discussed 403b and the option to fund an IRA.  None of these provide inflation protection guarantees.  It will entirely depend on your choice of investments.

Best to Worst Inflation Protected Assets

When retirement hits, many investors view it as a time to protect their assets, be conservative and focus on bonds and cash with a small amount in stocks.  This is a basic asset allocation for retirement.  Out of all three, stocks are the only one to offer significant growth beyond inflation.  But it comes with other risks.

To much emphasis on inflation protection can have a negative effect if inflation never materializes.  That said, the assets that offer better protection from high inflation rates include:

Best

  • Treasury Inflation-Protected Securities (TIPS)
  • Commodities
  • Real Estate
  • Stocks

Worst

  • Bonds
  • CDs
  • Savings Account
  • Cash

While inflation is a concern, worrying over a 2% or 3% inflation rate shouldn’t be alarming.  The worry should be if/when inflation rates rise, are you flexible enough with your portfolio to adjust to the rising financial risks.

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Comments

  1. says

    Good post. I agree that many retirees look to get very conservative once they hit retirement. While nobody is saying they should have an excessive allocation to stocks and other risky assets, they do need to have enough growth potential built in to keep ahead of inflation. As you point out even a seemingly low 3% inflation rate can erode purchasing power over a normal retirement period. A 3% rate of inflation will cut one’ purchasing power in 1/2 every 24 years.

    • J.P. says

      A bond heavy portfolio may not be so conservative with a potential increase in interest rate and inflation risk. I guess my point being is the age in bonds allocation strategy isn’t an absolute rule and folks should make adjustments accordingly. Thanks Roger.

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