Why Can Inflation Be a Risk for Investors?
When you invest, one obvious risk is that the investment itself may fall in value. But there is another risk that can matter even when the investment increases in value: inflation.
Inflation means that prices rise over time, reducing the purchasing power of money. If the value of an investment grows more slowly than prices, the amount shown in pounds may have increased while the amount those pounds can buy has fallen.
For example, suppose an investment grows from £10,000 to £10,300.
The investment is worth £300 more than it was before, so it has produced a positive return in monetary terms. But that does not necessarily mean its purchasing power has increased.
If prices have risen faster than the investment over the same period, the £10,300 may buy less than the original £10,000 could have bought.
This creates an important distinction when thinking about investment risk:
An investment can increase in value without necessarily increasing your purchasing power.
The Inflation Calculator can help illustrate how rising prices can affect the purchasing power of money over time. In this guide, we will focus specifically on what inflation risk means for investors and why it exists alongside the possibility that investments themselves can rise or fall.
For a broader introduction to our calculators and guides covering saving, investing and long-term growth, you can also explore Saving & Investing.
What Is Inflation Risk in Investing?
Inflation risk is the possibility that rising prices reduce the purchasing power of the money your investment is ultimately worth.
It is different from the risk of the investment itself falling in value.
Suppose an investment produces a positive return. The amount shown in pounds has increased, but whether its purchasing power has increased depends partly on what happened to prices during the same period.
This means there are two changes to consider:
- the return produced by the investment; and
- the change in prices caused by inflation.
Comparing them helps show whether investment growth has kept ahead of rising prices.
Two investments can both produce positive returns while having very different outcomes when their growth is compared with inflation. The investment has grown faster than prices over the period, so its purchasing power has increased. The investment has increased in pounds, but prices have risen faster, so its purchasing power has fallen. A positive investment return does not automatically mean an increase in purchasing power. What matters is how the investment’s growth compares with inflation over the same period.Investment Growth vs Inflation
Growth stays ahead of inflation
Inflation grows faster
The investment has produced a positive return in both examples.
What changes is whether that return was sufficient to keep pace with rising prices.
In the first scenario, the investment grows faster than inflation. In the second, the investment is worth more in pounds but prices have risen even faster.
That is why inflation risk can exist even when an investment has not fallen in value.
What Is the Difference Between Investment Return and Purchasing Power?
An investment return measures how the value of an investment has changed over a particular period.
Purchasing power describes something different: what the resulting amount of money can buy.
Suppose an investment rises from £20,000 to £21,000.
The £1,000 increase represents a 5% investment return before considering other factors such as investment income, fees or tax.
But the 5% return alone does not tell you how purchasing power changed. For that, inflation during the same period also matters.
A return stated without adjusting for inflation is generally described as a nominal return.
A return that accounts for inflation is known as a real return.
This distinction allows two different questions to be answered:
Nominal return: How did the investment change in money terms?
Real return: How did the investment change after accounting for inflation?
The detailed calculation of real returns is outside the scope of this guide. Nominal vs Real Returns explains the distinction and calculation in more detail.
For inflation risk, the important principle is simpler:
Investment growth and growth in purchasing power are not necessarily the same thing.
Why Does Unexpected Inflation Create Additional Risk?
Inflation risk is not only about whether an investment keeps pace with inflation today. There is also uncertainty about what inflation will be in the future.
When exploring a long-term investment scenario, you might make assumptions about both investment growth and inflation.
The difficulty is that neither can be known with certainty in advance.
Suppose a projection suggests that an investment could be worth £20,000 at some point in the future.
Even if the investment eventually reaches exactly £20,000, the purchasing power of that £20,000 will depend partly on how much prices increased along the way.
The investment reaches the same £20,000 future value in both scenarios. What changes is the rate at which prices have risen.
The investment reaches £20,000 and inflation is consistent with the 2% assumption used when considering its future purchasing power.
The investment still reaches £20,000, but prices have risen faster than assumed. The same £20,000 therefore has less purchasing power than originally anticipated.
The investment itself has not underperformed the projection: it reaches £20,000 in both scenarios. What changed was inflation. Higher-than-expected inflation means the same future amount of money can have lower purchasing power than originally assumed.
Expected Inflation vs Actual Inflation
Inflation as expected
2% inflation
Inflation higher than expected
5% inflation
This isolates an important part of inflation risk.
The investment itself does not necessarily have to perform worse than expected for the eventual outcome to be less valuable in real terms.
Inflation can be different from what was assumed.
This uncertainty can become increasingly relevant over longer periods because differences in the rate at which prices rise can accumulate over time.
A projection can therefore be useful for exploring possible outcomes, but it cannot tell you with certainty what the future purchasing power of an investment will be.
Does Investing Protect Your Money From Inflation?
Investing can provide the potential for money to grow faster than inflation, but investing does not automatically protect purchasing power.
Investment returns are uncertain.
There may be periods when an investment grows faster than prices, periods when it grows more slowly and periods when the investment itself falls in value.
This means an investor can face both investment risk and inflation risk at the same time.
For example, if an investment falls in value, the investor may have less money than before. If the investment rises but grows more slowly than inflation, its monetary value may be higher while its purchasing power has declined.
A positive investment return should therefore not be interpreted as guaranteed protection against rising prices.
It is also important not to assume that every investment responds to inflation in the same way. Different investments can behave differently as economic and market conditions change.
Past periods in which an investment grew faster than inflation do not establish that it will continue to do so.
The relevant principle is therefore not that investing protects against inflation, but that investing provides the potential for returns that may or may not exceed inflation over a particular period.
Inflation Risk vs Investment Risk
Inflation risk and the risk of an investment falling in value can both affect the eventual value of an investment, but they operate differently.
Investment-Value Risk
The market value of the investment itself can fall. For example, a £10,000 investment could decline to £9,000, leaving the investment worth fewer pounds than before.
Inflation Risk
The investment can increase in pounds but still fail to keep pace with rising prices. For example, an investment could rise from £10,000 to £10,300 while inflation rises faster over the same period.
Both can weaken the real-world outcome of investing, but for different reasons. Investment-value risk concerns what happens to the investment itself, while inflation risk concerns what the resulting money can buy.
The distinction matters because looking only at whether an investment balance has risen or fallen does not give a complete picture.
An investment that falls in market value has clearly experienced a monetary loss over that period.
Inflation risk can be less obvious because the number of pounds may still be increasing.
That does not make inflation risk equivalent to a market loss. It means the eventual value of an investment needs to be considered in the context of what that money may be able to buy.
What Is Investment Risk? explores investment risk more broadly and explains why uncertainty can take different forms when investing.
How Can You Explore the Effect of Inflation?
Because inflation affects purchasing power rather than simply changing the number shown in an investment account, its long-term effect can sometimes be difficult to visualise.
The Inflation Calculator lets you explore the relationship using different amounts, inflation rates and time periods.
For example, you can change the assumed inflation rate and see how that affects the future amount of money needed to maintain equivalent purchasing power.
Extending the time period can also demonstrate why relatively small differences in inflation may become more significant when they continue for many years.
The calculator is not a prediction of future inflation.
It answers a hypothetical question:
What would happen to purchasing power if inflation followed the assumptions entered?
That makes it useful for exploring scenarios without implying that a particular inflation rate will actually occur.
The Investment Growth Calculator approaches the broader relationship from the other direction. It allows you to explore how an invested amount could develop over time using an assumed investment return.
The two calculations therefore focus on different parts of the picture.
Investment growth affects how much money an investment may become worth. Inflation affects what an amount of money may be able to buy.
Neither future investment returns nor future inflation can be known with certainty, which is why calculator results should be treated as illustrations based on assumptions rather than forecasts.
Conclusion
Inflation adds another dimension to investment risk.
An investment does not necessarily need to fall in value for its eventual purchasing power to decline. It can produce a positive return in pounds but still grow more slowly than prices.
This is why investment return and purchasing power need to be distinguished.
Investment performance determines how the investment itself changes. Inflation independently affects what the resulting money can buy.
Future inflation is also uncertain. An investment could reach the value assumed in a projection while its purchasing power turns out lower than expected because prices rose faster than anticipated.
Investing can provide the potential to grow money faster than inflation, but it does not guarantee protection from rising prices.
Inflation risk is ultimately the risk that the money your investment becomes worth will buy less than expected — even when the investment itself has increased in value.
