Bulls n' Bears

Risks due to Inflation and an Example of Purchasing Power

Below there is a simple example of one of the risks due to inflation also known as purchasing power risk, and it basically means there is a chance that the cash flows from a particular investment will not be worth as much in the future because a change in purchasing power has occurred due to inflation.

How it works, and lets say you have a capital investment of $1.000.000 in bonds with a 10% coupon. This investment may provide enough in interest payments for a person to live on, however lets assume a 3% inflation rate. This means that every $1.000 returned by your investment shall be worth $970 the following year, and roughly $940 the year after.

So one of the risks due to inflation is that interest payments have less and less purchasing power. And your investment when returned after a few years will buy quite substantially less than when you originally purchased the bonds.

Its worth pointing out here that the risks due to inflation is not that there won't be inflation, the risk is that inflation will be higher than expected. Which is the main reason analysts are so concerned and speculate constantly regarding inflation rates, studying various indicators which could give them a clue as to where rates are heading.

It was during the 1970's there was record inflation which is now of course history, however risks due to inflation are still a major concern for income investors. Inflation means that money over a period of time loses value, and any investment which involves cash flows is exposed to this risk.

The implications of which are serious, the investor receives a lower rate of return than expected which in some cases can cause the the investor to withdraw some or all of the portfolio should they be dependent on it for income.