Inflation reduces the purchasing power of money, causing risk to long-term investments like stocks and bonds. Investing in commodities is advised to avoid inflation risk, but it can also be dangerous. Inflation can be caused by political turmoil, resource scarcity, and inflationary psychology.
Inflation occurs when the prices of goods and services rise, reducing the purchasing power of money in an economy. When there is a risk of inflation, there is a chance that inflation could be higher than expected by economists and financial analysts. This type of risk can be especially detrimental to long-term investments like stocks and bonds. An investment can lose value over a period of years if the money in the investment loses its purchasing power. Inflation risk is especially dangerous because there’s no avoiding it as money itself loses value, even if it isn’t invested in risky stocks.
Individuals and businesses with investment portfolios are often advised to invest intelligently to avoid the problems associated with inflation risk. It can be helpful to consider this type of risk in terms of short-term and long-term risk. Inflation happens frequently in most economies, meaning that short-term inflation is often minor and unavoidable, and generally causes a stock or bond to lose returns for a year or two. Once money regains its purchasing power, however, stock or bond values can rise again, meaning long-term inflation isn’t as bad as short-term inflation.
Investing in commodities is sometimes advised to investors as a good way to avoid inflation risk. Commodities are materials such as oils and metals which are commonly purchased by industries. During inflation, the value of these commodities increases, which means that investments in these commodities can generate higher returns than stocks and bonds in the capital markets. However, other experts believe that investing in commodities can also be dangerous, since they have no value if they are not purchased. Additionally, some experts speculate that inflation caused by the higher cost of some commodities could end up lowering the value of other commodities.
A number of factors, such as political turmoil and resource scarcity, can lead to a high degree of inflation risk. In some cases, inflationary psychology is a cause of inflation. This is a phenomenon where consumers invest in the precious metals and commodity markets, such as oil and gold, because they are afraid of inflation. By taking money from the capital markets of stocks, bonds and other long-term assets, they end up effectively creating the inflation they are trying to avoid by raising the value of commodities and lowering the purchasing power of their money.
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