Investment Risk from Inflation

Inflation risk is the threat of rising prices eroding the buying power of your money. In many cases, saving rates have been lower than inflation, meaning that the returns savers are making on their money are not enough to keep up with the rising cost of living.

Inflation risk to savings

Since you will pay tax on your savings, then you need to earn an even higher interest rate to keep pace with inflation after tax has been deducted.

If, for example, inflation is at 4% and you pay the basic rate, 20% tax on your interest, then your money would need to be in an account paying 5% for the real value of your money to remain the same, and higher than 5% for it to go up.

This means keeping all of your savings in cash is not actually a 'risk free' solution, as is often thought to be the case. If the returns you get on your money are unable to at least match inflation, then your money will effectively be losing value each year.

Inflation risk in retirement

This can be a big risk at any stage of your life but can be particularly damaging when you're retired, as you would typically not want to expose your money to risky assets such as equities (stocks and shares). So if you're not receiving interest equivalent to inflation, the value of the pension pot you have built will effectively be falling.

There are several index-linked savings accounts and investment products available, which are built to beat the risk of inflation, although they often require you to lock your money up for a number of years. These work well if inflation remains high but if it drops during the term of your agreement then you might miss out on higher returns elsewhere.

How to beat inflation through investing

Investing your money on the stock market is often seen as the best hedge against inflation. Taking on additional risk with your savings can potentially provide returns that outstrip the rising cost of goods. However, taking on this additional risk means you could also lose money. Of the different types of investments, stocks and shares, or equities, are generally used as a hedge against inflation.

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