What is Purchasing Power Risk? (How Inflation Steals From You)

Purchasing Power Risk Explained 

Most people have experienced the effects of purchasing power, whether they realize it or not. Purchasing power risk reflects the possibility that your savings can’t be stretched as far tomorrow as it can be today. Put another way; there’s always a risk that your money, whether dollars, pounds, or euros, will buy fewer goods and services in the future than it will at present. That risk has a name, and it’s inflation.  

Let’s say you tuck your savings under your mattress today to buy a comic book later. Discipline today should lead to benefits later. However, purchasing power risk positions the dollar’s worth today vs. what it will be worth tomorrow. It threatens to diminish the value of fiat money so that it can no longer afford the same item later on — not because the price of the comic book went up but because of the currency’s depreciation. You kick yourself for not spending your savings sooner. 

The culprit behind purchasing power risk is inflation, which eats away at the purchasing power of consumers and businesses alike. Inflation represents the increase in prices for goods and services in the economy. So the higher inflation rises, the less purchasing power you possess. Scary, right? So how do you avoid purchasing power risk? The only way to do so is not to leave your money idle in savings. Think about corporations and the cash they have sitting on their balance sheets. They put that money to work for them by investing it in stocks, gold, or if you’re MicroStrategy or Tesla — bitcoin. If you want to avoid purchasing power risk, you might want to do the same. 

Inflation Risk Defined

Inflation risk is sneaky and usually doesn’t rear its head overnight. Instead, prices creep up little by little over time until suddenly you are facing sticker shock at the grocery store or gas pump. In the U.S, the inflation gauge is the Consumer Price Index (CPI), which serves as a harbinger when prices rise faster and higher than wages. 

Let’s use an example of how purchasing power risk and inflation serve as a one-two punch in the economy using something that doesn’t go out of style — a cup of Joe. Fifty years ago, you could buy a cup of coffee for $0.25. As of 2022, that price tag had risen to $4.90 per cup, on average. It’s the same cup of coffee, but the price tag has jumped significantly. If you had $10, you could purchase 40 cups of coffee in 1970 vs. a mere two full cups of coffee today. 

Fortunately, there are ways to beat inflation risk in your investment portfolio. When you are deciding how to allocate your assets, you should think in terms of outperforming inflation. This could mean ratcheting up your risk/reward profile so that you come out on the winning side of the battle. If your portfolio generates 6% annual returns and inflation is running at 3%, you have conquered the purchasing power risk threatening to diminish your returns further.   

This is precisely why you want to invest in assets rather than just socking away your fiat money in a bank. Inflation rates have been running amuck in 2022 and have reached multi-decade highs. Meanwhile, interest rates, which tend to move in the same direction as inflation, are similarly at their highest level in decades in a futile attempt by central banks to combat unwieldy inflation.  

Purchasing Power Risk Bonds 

You've got options if you want to diversify your investment portfolio to defend yourself against purchasing power risk. One of them is Treasury Inflation-Protected Securities or TIPS. The U.S. government issues these securities, which, as the name suggests, are designed to protect investors from the damaging effects of inflation and purchasing power risk. While TIPS are a type of bond, they flip the traditional model on its head. 

Traditional bonds typically increase yields in response to inflation to offset the purchasing power risk. With TIPS, when inflation rises, the price or principal amount of the security adjusts instead of seeing yields increase. As a result, the value of the investment manages to remain intact. The interest payment may vary based on the resulting price of the security, but the principal amount is protected, thereby saving investors from suffering a loss.  

Which Investment Gives the Greatest Protection Against Purchasing Power Risk? 

When making your investment decisions, consider which assets will give you the greatest protection against purchasing power risk. If you could gain exposure to inflation hedges, you are less likely to be affected by any headwinds in the economy, though there are no guarantees. Commodities are primarily considered to offer the best protection against purchasing power risk, though 2022 has been an anomaly.

• Gold: Gold has a history on its side as an inflationary hedge. The precious metal has a reputation for being a safe-haven asset that protects against inflation risk and purchasing power risk. If you are willing to buy and hold for the long term, gold could be an effective diversifier in your investment portfolio over the years. Historically, gold has proven to increase in value even as the dollar depreciates. However, gold does not always rise to the occasion, as investors had seen in 2022, when the price was trending lower for the year as of November, even as inflation hovered at multi-decade highs. 
• Cryptocurrencies: One of the primary use cases of cryptocurrencies is to serve as an inflation hedge, in addition to being used as a means of payment. The hedging characteristics of cryptocurrencies stem from factors such as their limited supply, which varies depending on the specific cryptocurrency. Unlike fiat money, which is subject to the discretion of central bankers and the operation of money printers, cryptocurrencies offer a more predictable and finite supply. However, it's important to note that cryptocurrencies, similar to traditional assets like gold, have a relatively short trading history and are still navigating their path. In 2022, the price of many cryptocurrencies, including Bitcoin, experienced a downward trend alongside the broader financial markets. Various economic challenges, such as the possibility of a recession, increasing interest rates, and high inflation, have contributed to this uncertainty. Only time will reveal the extent to which cryptocurrencies, including PulseChain, can effectively protect against purchasing power risks.