Bulls n' Bears

Risks due to Inflation when making an Investment

Inflation risk arises from the uncertainty of cash flows due to the effects of inflation, measured by the value of purchasing power. For example, if an investor buys a five-year bond with a coupon of 7 percent, but at the same time, the inflation rate is 8 percent, it means that the purchasing power of cash flow has fallen down.

Many people are not experts in finance and prefer to invest their money in conservative, "safe" investments. These are some mutual funds, government securities or certificates of deposit, the cost of which is stable at the expiration of the time, but usually provide low returns. However, such investment may not be the best in practice because of the risks due to inflation. In simple terms, inflation eats the value of money and return on investment should be high enough to outstrip inflation. Inflation always decreases the value of income from investments.

Here is an example: Let us allow, investment provides an annual income equal to 6 percent and inflation 4 percent. In the way real income is equal to 2 percent (6 percent - 4 percent = 2 percent). Here, inflation has selected more than half the income. Imagine the worst case, when inflation is above the annual yield. So if an investment returns 3 percent per year while inflation is 4 percent, then real income will be 1 percent. This means that the investor will lose money in the so-called "safe" investments. You might also consider the effect of the impact of inflation over time. Assume that the investor had invested 45.000 USD in a box and what level of inflation is 4 percent per year.

After 10 years, inflation reduces the value of its money on more than 15,000 dollars. Over the next 15 years, the value of "investment" will drop by nearly 30.000 USD. After 25 years, the cost will be only 45.000 USD or about 15,000 less than half their nominal value. This means that if the first investor could buy goods at 45.000 USD then 25 years later he would be able only to goods 15.000 USD in using the same money. This was because inflation has reduced the value of money, and, thus, purchasing power.

Risks due to Inflation - the risks, which reduce the purchasing power of money. They are often seen as hidden risks because the investor is not watching it as a change in the value of the securities. However, although the risks due to inflation are hidden, they are worth remembering about them, and accordingly choose the right investment. There is only one method of dealing with the impact of inflation - is getting more than its income.