What is Inflation Risk?
Inflation Risk aka. “Purchasing Power Risk” is the risk due to “a decrease in purchasing power of assets or cash flow” due to inflation. A typical example would be a bond that generates a fixed rate of return.
For instance, suppose this bond is worth $1000 and generates a 5% yield i.e. $50. Suppose when you purchase the bond that $50 will buy two tanks of gas for your car. Over time inflation will reduce the purchasing power of that $50 so it only buys one tank of gas. If you are counting on using the proceeds of the bond to buy gas there is an “inflation risk” that eventually you will not be covered. The worst case example of inflation risk is if a country experiences “hyperinflation” where the purchasing power of the currency decreases on a daily basis.
Investing Answers puts it this way: Inflation risk, also called purchasing power risk, is the chance that the cash flows from an investment won’t be worth as much in the future because of changes in purchasing power due to inflation.”
Wall Street Oasis says, “Inflation risk is the risk any investor takes on when holding cash or investing in an asset which is not linked to inflation. The risk is that the cash value will be reduced by inflation. For example, if an investor holds 40% of a $1,000,000 portfolio in cash and inflation is running at 5%, the cash value of the portfolio will lose $20,000 per year ($1 million x 0.4 x 0.05) due to inflation.”
Being able to identify and manage financial risks is a very important responsibility for all individuals and business owners. One financial risk that many people underestimate is the risk associated with inflation. While inflation tends to devalue your money over time, there are steps that can be followed to help manage this risk.
Mitigating Inflation Risk
Some investments are better at mitigating inflation rask than others. Obviously any fixed rate investment such as bonds, money-market funds, CD’s, bank deposits, etc are all very poor at mitigating inflation risk. On the other hand, some investment vehicles like Inflation Indexed Bonds are supposed to be designed to perform better. Rental property in most locations will allow you to “raise rents” to mitigate inflation risks, stocks generally increase more than inflation because the companies can increase their prices to cover increasing costs. Commodity based businesses like oil companies are also fairly immune to inflation but can be subject to other risks such as geo-political risks and general economic malaise.
Invest in Cash Flow
When you are looking to manage your inflation risk, one option is to consider investing in cash flow. When you make investments in entities that will provide you with regular cash flow, you will have the ability to see this cash flow increase when the inflation rate increases. Cash flow from strong entities tends to offset inflation risk and will help to keep your money valuable in the future.
Manage Your Credit Risk
Another way that you can manage your financial risk is by managing your credit risk. If you are lending money to individuals or businesses, or simply giving them good repayment terms, you are taking on both credit risk and inflation risk. The longer that their debt is outstanding, the more risk you are taking on in terms of inflation. One way to manage this risk is through an accounts receivable risk analysis service such as CreditRiskMonitor that will help you to identify credit risks and create a strategy to mitigate this risk.
Charge Interest or Fees
If you are concerned about the inflation risk you are taking on when you lend money or give attractive repayment terms, another option would be to charge interest or late payment fees. When money owed you is outstanding for too long, that money is slowly declining in value so during times of high inflation a clause is often added to loans to adjust for inflation. Typically that is based on the CPI-U or Consumer Price Index for All Urban Consumers.
Invest in Inflation Resistant Commodities
When you are developing a strategy to manage inflation risk, you should consider investing in inflation-resistant commodities. Investing your capital in gold, oil, and other Commodities can be a good idea as these tend to increase in value when inflation increases. This will allow you to hedge against the risks that come with inflation increases.
One key strategy in risk prevention is exemplified by the old saying “don’t put all your eggs in one basket”. By diversifying across a variety of different asset classes you can minimize your inflation risk. So in addition to commodities, stocks, inflation indexed bonds, and real estate you can hold some assets that are denominated in different currencies. Since each currency is subject to different inflationary pressures based on their own country’s monetary policy they inflate at different rates so if you hold “stronger” currencies they will appreciate against your home currency thus providing protection against a loss of purchasing power.
For example, imagine you lived in Zimbabwe during their hyperinflation period. The common practice was to accept payment in U.S. dollars to avoid the inflation risk of the Zimbabwe dollar. Even though this was illegal people felt it was worth the prosecution risk to avoid the inflation risk and eventually the government could no longer keep up the pretense of their own currency and succumbed and made the U.S. dollar the defacto legal tender of Zimbabwe.
Due to the serious cost associated with inflation, finding good ways to hedge against it is extremely important. Fortunately, there are strategies that can help any individual or company to hedge against their inflation risk.
For more information See:
- What is Hyperinflation? Contains a list of 27 examples of hyperinflation from ancient Egypt through modern day North Korea (2011).
- How Does Gold Fare During Hyperinflation?
- Hyperinflation of Weimar Germany
- Confederate Hyperinflation Rates
- Surviving a Hyperinflation
- Syria in the Throes of Hyperinflation (2013)
- Zimbabwe Hyperinflation and the U.S. Dollar (2009)
- Zimbabwean Hyperinflation Officially Estimated At 2.2 Million Percent (2008)