Economists Use Inflation to Describe a Rise in Price Level

Inflation occurs when the general price of the goods and services you are buying are rising and, as a result of the increase in cost, the purchasing power of your money is falling. The term may also be used to describe a rising price level within a narrower set of assets, goods or services within the economy. These include commodities (such as food, fuel, metals), tangible assets (such as real estate), financial assets (such as stocks, bonds), services (such as entertainment and health care), and labor.

Most economists today use the term inflation to refer to a rise in the price level. An increase in prices is called price inflation, which distinguishes it from monetary inflation, which occurs when there is a rise in money supply. Other economic terms related to inflation include:

  • Asset Price Inflation – a general rise in the prices of financial assets without a corresponding increase in the prices of goods or services.
  • Deflation – a fall in the general price level.
  • Disinflation – a decrease in the rate of inflation.
  • Hyperinflation – an out-of-control inflationary spiral.
  • Reflation – an attempt to raise the general level of prices to counteract deflationary pressures.
  • Stagflation – a combination of inflation, slow economic growth, and high unemployment.

The rising costs/loss of purchasing power affects economies in various ways; both positive and negative. As a consequence, there are hidden costs to some and benefits to others. From a negative perspective, the uncertainty about the future purchasing power of money discourages investing and saving. For example, inflationary expectations and interest rates will determine the risks associated with bond investments. Inflation is a bond’s worst enemy; it erodes the purchasing power of a bond’s future cash flows.

Generally speaking, economists favor a low and steady rate of inflation. This is because a low figure, as opposed to zero or negative, reduces the chance that an economic recession will occur, and it reduces the risk that inflation will undermine the performance of your investment portfolio.

The Five Greatest Risks Facing Investors Investing in Bonds

Although bonds are a great tool to generate income, and are widely considered to be a safe investment especially when compared to the risks of investing in stocks, investors need to be aware of some of the potential challenges to holding corporate and/or government bonds.

The greatest risks posed to bond investors are:

  1. Interest Rate Risk
  2. Reinvestment Risk
  3. Inflation Risk
  4. Default Risk
  5. Liquidity Risk

Interest Rate Risk

Interest rates and bond prices enjoy an inverse relationship. As interest rates fall, the price of bonds trading in the marketplace generally rises. Conversely, when interest rates rise, the price of bonds is likely to fall.

Reinvestment Risk

Another challenge facing bond investors is something called reinvestment risk. This is the risk of having to reinvest investment proceeds at a rate that is lower than the funds were previously earning. Over time, this reinvestment risk can have an adverse effect on an investor’s investment returns.

Inflation Risk

If the cost of living and inflation increase dramatically, and at a faster rate than income investment, investors will see their purchasing power erode and may actually achieve a negative rate of return.

Default Risk

When investors purchase bonds, they are actually purchasing a certificate of debt. This is money that is borrowed and must be repaid by the company over time, with interest. The risk with this is that corporate bonds are not guaranteed. Instead, these bonds depend greatly on whether the company is able to repay that debt.

Liquidity Risk

Although there is almost always a market ready to purchase government bonds, corporate bonds are sometimes entirely different. There is a risk that an investor might not be able to sell his or her corporate bonds, or may be forced to take a much lower price than expected to sell the bond.

Accounting For Bond Risks

Aside from interest rate risk, which is the most well-known of risks in the bond market, reinvestment, default, and liquidity risk should also be closely considered when choosing to pursue a bond investment.

In an effort to protect themselves, investors can can learn more about the risk of different bonds from a credit rating agency like DBRS, Fitch, Moody’s or Standard & Poor’s. These agencies rate the issuer’s ability, in the opinion of the agency, to make regular interest payments and to pay investors back when the bond matures.

Additionally, investors should read investment reviews and adopt a strategy that chooses a mix of bonds with different features. This increases the odds that some of your bonds will perform well at times when others do not. Investors should consider buying a mix of government and corporate bonds that contribute to a well-built portfolio, and account for financial goals and tolerance for risk.

Strategies to Manage Risks of Investing in The Stock Market

There are many country specific and industry specific risks when investing. Because there is a tentative relationship between the government and businesses, there is always a risk that government actions could constrain an industry or corporation. Likewise, business executives could make poor decisions or get caught-up in a scandal. Without a doubt, such actions would adversely affect an investor’s holdings in that business and/or sector.

As an investor, the best thing you can do is read reviews, educate yourself and know the risks before investing in something. This cautious approach will encourage you to:

  1. Seek Advice
  2. Diversify Your Portfolio
  3. Make a Long-Term Commitment

Strategy One: Seek Advice.

When you don’t understand how the stock market works – like what makes a stock’s price rise or fall, it becomes an especially risky investment. The more you know, the more you can lower this risk.

If you don’t feel comfortable with your understanding of an investment, ask experienced investors to help you choose stocks and other alternatives that help you achieve your financial goals, as well as meet your tolerance for risk.

Strategy Two: Diversify Your Stock Portfolio.

You can reduce your overall risk by owning stock in companies of different sizes and different industries. As well, different types of stock offer fixed returns that can be counted upon to offset losses in other investment areas.

  • Type of industry – While companies in one industry may be struggling, companies in another industry may be performing well. For example, manufacturing stocks might slump when technology stocks rise.
  • Company size – Investing in a small, new company has the potential for higher growth. That said, it is usually riskier than a larger, more established company would be.
  • Type of stock – Preferred shares tend to offer lower risk and returns than common shares. But, unlike common shares, preferred shares pay a fixed dividend. You may want to choose both for your portfolio.

Strategy Three: Make a Long-Term Commitment.

As I am sure you are aware from the recent U.S. elections and the Brexit vote, the stock market is subject to short-term fluctuations and bear markets. Volatility aside, historically the stock market has performed well over the long term.

Because of the uncertainty associated with the stock market do not invest with money that you will need back soon. If you do, you run the risk of being forced to sell during a period when a stock’s price is low.

When risks affect the market or the economy, investors must rely upon their well-constructed portfolio to protect their investments. Making educated investment decisions that work toward your goals, and are mindful of your exposure to adverse conditions, will keep investing risks at an acceptable level.