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Inflationary Risk Definition

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Investors discuss how to deal with inflation riskWhen building an investment portfolio there are certain types of risk you have to factor in, including inflation risk. You may know that inflation means a trend of rising prices over time but you may not understand how this can be a threat to your investment returns. The good news is that there are things you can do to manage inflation risk while investing to minimize its impacts on your portfolio and boost total return. Consider linking up with a trusted financial advisor to minimize the impact of inflation on your portfolio.

Inflationary Risk, Explained

Inflationary risk (also called inflation risk or purchasing power risk) is a way to describe the risk that inflation can pose to a portfolio over time. Specifically, it refers to the possibility that rising prices associated with inflation could outpace the returns delivered by your investments.

When inflation trends on the higher side, that can directly affect your purchasing power, despite the face value returns on your investments. In other words, your portfolio has to work that much harder to help you maintain the same level of purchasing power the more inflation and prices rise.

Inflation risk can affect individual investment returns as well as your portfolio’s overall return. Say that you have an investment that’s returning 2% annually, for example. At the target inflation rate of 2%, you’d essentially be breaking even with that investment since you’d have a zero net return. But say inflation rises to 3%. You’re now looking at a negative 1% return on that same investment.

Rising inflation can be caused by a number of factors. When the economy is growing quickly, for example, that can spur inflation if there’s an uptick in demand for consumer goods and services while supply remains the same. Inflation can also be triggered when there’s a general rise in prices for the supplies or raw materials manufacturers need to produce the things they sell. Those price increases then get passed on to consumers, resulting in inflation when higher prices are sustained over time.

Inflationary Risk and Your Portfolio

Waves wash away dollar sign in the sandInflationary risk can be detrimental to your portfolio because of how it affects purchasing power over time. Even if your portfolio is doing well and delivering returns above your expectations, those returns may not go as far if inflation is steadily trending upward. Inflation risk can pose more of a threat to certain types of securities than others.

Fixed-income securities are particularly susceptible to inflation risk since these investments are typically over a stable or guaranteed rate of return over time. For example, say you invest in government bonds that offer a 5% fixed rate of return. Inflation is at 2% when you buy the bond, but over time, it begins to increase year over year.

In that scenario, you’re essentially increasing the odds of reduced purchasing power the longer you hold the bonds. With something like a stock or mutual fund, on the other hand, you have more flexibility in deciding whether to sell the security to minimize the impacts of inflation.

Some investments can be considered a hedge against inflation and more insulated from its effects. Real estate is a prime example since generally, homes and land tend to appreciate in value over time even when inflation is occurring. In some cases, you may even benefit from rising inflation. If you own a rental property, for example, you might be able to raise your rental rates consistently to keep up with rising inflation which can help offset any increased costs associated with owning and maintaining the property.

Other types of investments have built-in safeguards against inflation. Treasury Inflation Protected Securities (TIPS), for example, are inflation-indexed, which means their coupon rates and principal payments are adjusted for inflation so that investors can continue receiving a consistent real return from their investments.

How to Minimize Inflation Risk When Investing

Rope squeezing a dollar bill

If you’re worried about how inflation risk could affect your portfolio there are some things you can do to help downplay the risk. First, if you own bonds or similar fixed-income securities it’s important to understand how and when they mature. Bonds with shorter durations may be the better option for shielding your portfolio against inflation, especially if interest rates are also rising. Once the bonds mature, you could sell them to capitalize on higher interest rates versus staying locked into a long-term bond whose performance lags behind the inflation rate.

Besides adding TIPS to your portfolio, considering diversifying your portfolio with a mix of growth and value stocks can also be helpful for managing the effects of inflation. Growth stocks represent companies that have above-average growth potential. While they typically don’t pay dividends to investors, they can make up for that with above-average returns. Many value stocks, on the other hand, are established companies that have a solid track record of delivering dividends and have the potential to appreciate in value over time. Both can help with fighting off inflation risk over the long term.

Beyond stocks, you can also explore alternative investments. Again, real estate can be a great option for hedging against inflation and there are numerous ways you can own. For instance, you could buy a rental property, invest in crowdfunded real estate, buy shares in a real estate mutual fund or ETF or invest in a real estate investment trust (REIT). With REITs and real estate crowdfunding, you get all the tax benefits of owning property without having to actually play the landlord’s role.

Aside from real estate, you might also consider investing in commodities to manage inflationary risk. Things like wheat, gold, oil and other raw materials tend to be better insulated against inflation risk since they usually remain in demand even when prices rise. Keep in mind, however, that commodities can also be more volatile than stocks or real estate since they can be affected by things like currency risk, political risk and legal risk. Keeping your portfolio well-diversified can help with balancing out the various risk profiles of your investments.

The Bottom Line

Inflation risk isn’t something to overlook when constructing and managing your investment portfolio. By actively introducing strategies designed to offset or minimize the effects of inflation you can better drive returns in your portfolio over time.

Tips for Investing

  • Consider talking to a financial advisor about how well your portfolio is protected against inflation risk. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • If your investments aren’t providing returns equal to or greater than the inflation rate, you’re probably in trouble. You’ll find yourself making tough choices about what you can afford as inflation eats into your purchasing power. A free inflation calculator can help you sort through your options for mitigating inflation risk.

Photo credit: ©iStock.com/Jirapong Manustrong, ©iStock.com/imagedepotpro, ©iStock.com/sorendls

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