Purchasing power risk
Also known as: inflation risk
Purchasing power risk is the risk that inflation will erode the real value of an investment's returns, so the dollars you get back buy less than the dollars you invested. It hits fixed-income investments hardest.
Purchasing power risk — better known as inflation risk — is the danger that rising prices will reduce what an investment's future payments can actually buy. An investment can post a positive nominal return and still lose ground: if a bond yields 3% while inflation runs 4%, the investor's real return is negative.
Fixed payments are the most exposed. A bond paying $50 per year pays that same $50 whether a basket of groceries costs $100 or $150, so long-term bonds, fixed annuity payments, and preferred stock with its fixed dividend bear the most purchasing power risk. The longer the time horizon, the more the erosion compounds — which is why a 30-year bond carries far more inflation risk than a 1-year note.
The classic defenses are investments whose income or value can rise with prices. Common stocks historically outpace inflation over long periods because companies can raise prices and grow earnings, and Treasury Inflation-Protected Securities (TIPS) adjust their principal with the Consumer Price Index. Ironically, the "safest" assets — cash and short-term government debt — are among the most vulnerable to this particular risk.
Purchasing power risk shows up in the suitability sections of the SIE, Series 7, and Series 65 exams. Expect questions pairing it with fixed-income and preferred stock investments, and answer choices that hedge it with equities or TIPS.
Key takeaways
- Purchasing power risk is the risk that inflation erodes the real value of investment returns.
- Fixed-income investments — long-term bonds, fixed annuities, preferred stock — are the most exposed.
- Real return is roughly the nominal return minus the inflation rate.
- Common stock and TIPS are the standard hedges against inflation risk.
- Low-volatility assets like cash can still carry high purchasing power risk.