Inflation risk is the risk of your investments being outpaced by inflation. All low yield instruments have a chance to be outpaced by inflation. The lower the return, the higher the odds. Inflation reduces the power of money to purchase products, which also reduces the value of new money earned. If inflation matches your returns, you will retain the same purchasing power. If inflation exceeds your returns your ability to buy an equal set of goods will slowly erode.
Retain Purchasing Power
The goal of investing is to grow your capital while retaining and increasing your purchasing power. Your portfolio’s return must be substantially higher than the rate of inflation. Bonds return at a specific rate for their duration. If you purchase a bond before or during a time period of substantial inflation your real return will be hampered. Similarly, if the return on your bond is barely above the inflation rate, the real return will be quite low.
You must exceed the inflation rate to eliminate the effects of inflation. As inflation rises, the need for higher returns follows. During times of high inflation, being locked into low return bonds is detrimental to your earnings. Shifting your portfolio allocation towards higher yield instruments like equities makes overcoming the inflation rate easier. When inflation returns lower you can shift back into bonds to provide yourself with financial stability.
Go The Inflation Adjusted Route
You can also offset inflation risk by purchasing inflation adjusting securities. Your par value is adjusted to increases in the cost of living while your interest rate is held steady. If inflation rises the par value is positively adjusted by the same amount. New interest payments are based on the adjusted par value. This means your returns are generated from constantly adjusted principal. The majority of inflation adjusting bonds are issued by first world nations. Australia, Canada, France, Germany, Iceland, Japan, Sweden, the United States, and the United Kingdom all offer inflation adjusting bonds.
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