Inflation risk, also known as purchasing power risk, is the possibility that the value of your investment returns will be diminished by rising prices over time. When inflation increases, the same amount of money buys fewer goods and services.
For example, if your investment earns a 5% return but inflation is running at 3%, your real return is only 2%. In extreme cases, if inflation exceeds your investment returns, you actually lose purchasing power even though your nominal investment has grown.
To protect against inflation risk, investors can consider assets that historically outpace inflation, such as stocks, real estate, inflation-protected securities (like TIPS), and commodities like gold. Understanding inflation risk is crucial for long-term financial planning, especially for retirement savings.