Inflation as a risk to savers
The only guaranteed loss in finance, and the only one that never shows up on your account statement.
The invisible loss
If stocks fall 20%, you see it instantly. If inflation eats 20% of your purchasing power over seven years, your statement shows the same number and you notice nothing.
That is why people treat cash as "risk-free". It is volatility-free, which is a very different thing.
At 3% inflation, the purchasing power of your money halves in twenty-three years. That happens with certainty, not as a possibility.
What protects you and what does not
Historically, stocks have protected you over long periods, because companies raise their prices along with inflation. Over short periods they can suffer, especially when inflation rises suddenly.
Fixed-rate bonds are hit hardest: the coupon is fixed, and inflation eats away at its real value every year.
Real estate and commodities sometimes help, but not always, and they come with costs and complications of their own.
The number to watch
The return that matters is the real one: your return minus inflation. A deposit paying 4% in a year with 6% inflation is a real loss of 2%.
When you compare options, convert them all to real terms. Otherwise a high nominal rate looks attractive precisely when it is at its worst.
This is also the test for any "risk-free" promise: if the nominal return is below inflation, the certainty on offer is the certainty of a loss.
Nominal versus real return, at 5% inflation
| Where you keep it | Nominal return | Real return |
|---|---|---|
| Cash in hand | 0% | −5% |
| Deposit | 3% | −2% |
| Stock index (on average) | 8% | +3% |
Key terms in this lesson
- Nominal return
- The return before inflation is subtracted. The number that gets advertised.
- Real return
- The return after inflation — how much more you can actually buy.
- Inflation-linked bond
- A bond whose coupon and principal rise along with inflation.
Quick check
A deposit pays 4% while inflation is 6%. What happens to you in real terms?
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