Purchasing Power Risk

Purchasing power risk refers to the decline in the purchasing power of money over time, causing the value of money in the future to be lower than the value of money now. Purchasing power risk is primarily caused by inflation, which refers to a sustained increase in general price levels. Purchasing power risk has important implications for both investors and borrowers because it affects their actual returns and costs.

Impact of purchasing power risk

Purchasing power risk affects the actual returns and costs to investors and borrowers because they need to take into account future changes in the value of money. Generally speaking, inflation will be detrimental to investors and beneficial to borrowers, because inflation will reduce the real returns of investors and increase the real costs of borrowers.

For example, suppose an investor purchased a stock for 1,000 yuan a year ago and sold it for 1,100 yuan a year later. If the inflation rate during this year is 5%, then the investor's nominal rate of return is 10%, but his actual rate of return is 10%-5%=5%. In other words, his actual income is only 50 yuan, not 100 yuan. This means that his purchasing power has dropped by 50 yuan.

Conversely, suppose a borrower borrowed $1,000 a year ago at an interest rate of 5% and repaid $1,050 a year later. If the inflation rate during this year is 5%, then the borrower's nominal cost rate is 5%, but his actual cost rate is 5%-5%=0%. In other words, his actual expenditure was only 1,000 yuan, not 1,050 yuan. This means there is no change in his purchasing power.

Management of Purchasing Power Risk

Purchasing power risk cannot be completely avoided, but there are ways to manage and mitigate it. Here are some common ways to manage purchasing power risk:

Choose a portfolio that suits your risk appetite and goals. Different types of investment products have different risk and return characteristics. Some investment products can provide returns higher than the inflation rate, thereby maintaining or increasing purchasing power, such as stocks, real estate, gold, etc. Other investments can provide stable but lower income than the inflation rate, thereby losing some purchasing power, such as bonds, deposits, currency funds, etc. Therefore, investors need to choose a suitable investment portfolio based on their risk appetite and goals to balance returns and risks.

Choose investments or debt products with inflation protection or adjustment mechanisms. Some investments or debt instruments can be adjusted according to the inflation rate or price index to maintain or increase their real value. For example, some countries issue inflation-linked bonds (inflation-indexed bonds), in which both principal and interest increase with the rate of inflation. In addition, some contracts or agreements may also contain inflation protection or adjustment clauses, such as lease contracts, wage contracts, social security payments, etc.

Choose investments or debt products that are tied to the rate of inflation. The prices or returns of some investment products or debt products have a positive or negative correlation with the inflation rate, which can offset or mitigate purchasing power risks. For example, the prices of some commodities will increase with the inflation rate, such as oil, grain, metals, etc., so investing in these commodities can maintain or increase purchasing power. In addition, the exchange rates of some currencies will fall with the inflation rate, such as the US dollar, euro, Japanese yen, etc., so borrowing these currencies can reduce the actual cost.

Summarize

Purchasing power risk refers to the decline in the purchasing power of money over time, causing the value of money in the future to be lower than the value of money now. Purchasing power risk is primarily caused by inflation, which refers to a sustained increase in general price levels. Purchasing power risk has important implications for both investors and borrowers because it affects their actual returns and costs. 

Purchasing power risk cannot be completely avoided, but it can be managed and mitigated through some methods, such as choosing an investment portfolio that suits your risk preference and goals, choosing investments or debt products with inflation protection or adjustment mechanisms, and choosing investments that are related to the inflation rate. investment products or debt products, etc.