Inflationary risk is the risk that unanticipated inflation will diminish the future real value (after inflation) of an investment, asset, or income stream.
What is the impact of inflation risk?
Consumer spending, company investment, and employment rates are all affected by inflation, as are government programs, tax policies, and interest rates. In order to invest successfully, you must first understand inflation. Inflation can diminish the value of your investment returns.
For dummies, what is inflation risk?
Inflation is a risk that stock investors must consider. Inflation occurs when the quantity of money is artificially increased, resulting in an excess of money being utilized in exchange for goods and services. Inflation is visible to customers as increasing costs for products and services.
Purchasing power risk is another term for inflation risk. This simply means that your money will not buy as much as it once did. A dollar that bought you a meal in 1980, for example, barely purchased you a candy bar a few years later. This risk means that the value of your investment may not keep up with inflation, which is bad news for you, the investor.
Assume you have money in a bank savings account that is currently yielding 4%. This account is adaptable; if the market interest rate rises, so does the rate you earn in your account. Both financial and interest rate risk are eliminated from your account. But what if the rate of inflation is 5%? You’re out of money at that moment.
Inflation is a real and severe worry that should not be overlooked when evaluating risk in your investing selections.
Inflation is a sort of risk.
Inflation risk refers to when the price of products and services rises faster than expected, or when the same amount of money has less purchasing power. Purchasing Power Risk is another name for inflation risk.
How do you deal with the threat of inflation?
To counteract inflation risk, investors have two options: portfolio modifications and spending adjustments. Common inflation hedges, such as Treasury Inflation-Protected Securities (TIPS), commodities, and reduced bond exposure, are included in portfolio modifications. The focus of spending adjustments is on rule-based techniques to keep spending under control (after adjusting for inflation).
While portfolio modifications receive more attention, spending changes are more likely to be predictable and have a greater influence over time. They also have the benefit of being able to work in a variety of market scenarios, not simply those that we can foresee ahead of time.
Inflation destroys debt in what ways?
Your dollar would be worth 95% less today than it was in 1915 if you kept it in cash for the previous 100 years. This is due to the fact that the value of your money depreciates over time and may buy you less each year due to inflation.
Debt operates in a similar way. In nominal terms, the debt’s worth does not change (assuming you do not pay it off). However, the value of that loan depreciates over time in the same manner that currency does. In today’s dollars, $100 in debt would be worth less than $10 over the last 100 years. This is why using leverage during inflationary periods is so valuable. It lowers the value of your loan over time.
Deflation is different when it comes to debt
While inflation gradually erodes the value of debt, deflation has the reverse effect. It increases the debt’s value over time. This is how a mortgage can deplete your property value. Here’s another look at one of the graphs from before.
While the cost of goods and services is falling, the cost of debt is staying the same. In fact, it improves in contrast. This is why, if there is a negative inflation rate, it is critical to minimize or erase your debt.
Help me! Deflation is confusing
It can be difficult to understand the distinction between future dollars and today’s dollars. Especially if we haven’t dealt with deflation before. Another approach to demonstrate how deflation can effect your investment property mortgage is to consider the following scenario:
Let’s imagine you wanted to buy an investment property for $125,000 today and decided to take out a $100,000 mortgage on it. Most mortgage contracts are relatively similar in that, depending on the sort of mortgage you have, you must make either fixed or variable installments.
In this case, there is no inflation, but the bank adds $3,000 to the balance of your mortgage each year, in addition to any interest payments you due. You would pay the interest due at the conclusion of year one, and your principal sum would be boosted to $103,000. Do you find this to be an appealing proposition?
This means that if you have a 3% interest rate, you will owe a net of 6% every year. 3% in interest and 3% extra on top of the principal.
Hopefully, you’ve realized that while you’re employing leverage, deflation hurts a lot.
To summarize, when there is deflation, the value of your real estate declines, your cash flows drop, and if you are utilizing leverage, those drops are compounded. Remember, if there is deflation, you should not have a mortgage.
We have had inflation for over 50 years, why should you worry about deflation?
We can assume that if housing prices are a good hedge against inflation, they will also be a strong hedge against deflation. However, why should we be concerned about deflation?
What causes inflation, exactly?
- Inflation is the rate at which the price of goods and services in a given economy rises.
- Inflation occurs when prices rise as manufacturing expenses, such as raw materials and wages, rise.
- Inflation can result from an increase in demand for products and services, as people are ready to pay more for them.
- Some businesses benefit from inflation if they are able to charge higher prices for their products as a result of increased demand.
What exactly do you mean when you say inflation?
Inflation is defined as the rate at which prices rise over time. Inflation is usually defined as a wide measure of price increases or increases in the cost of living in a country.