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Inflation occurs when the prices of goods and services rise, lessening the purchasing power of money in an economy. When there is an inflation risk, there is a chance that the inflation might be higher than predicted by economists and financial analysts. This kind of risk can be particularly damaging to long term investments such as stocks and bonds. An investment can lose value over a span of years if the money in the investment loses its purchasing power. Inflation risk is especially dangerous because there is no way to avoid it since the money itself loses value, even if it is not invested in risky stocks.
Individuals and businesses with investment portfolios are often advised to invest smartly in order to avoid the problems associated with inflation risk. It may be helpful to look at this kind of risk in terms of short-term and long-term risk. Inflation occurs often in most economies, meaning short-term inflation is often minor and unavoidable, and generally only causes a stock or bond to lose returns for a year or two. Once money regains its purchasing power, however, the values of the stocks or bonds may rise again, meaning the long-term inflation is not nearly as damaging as the short-term inflation.
Investment in commodities is sometimes recommended to investors as a good way to avoid inflation risk. Commodities are materials such as oils and metals that are commonly purchased by industries. During inflation, the value of these commodities rises, meaning investments in these commodities can generate returns higher than the stocks and bonds in capital markets. Other experts believe counting on commodity investments can also be dangerous, however, since don't have a value if they are not purchased. Also, some experts posit that inflation caused by the higher cost of some commodities might end up lowering the value of other commodities.
A number of factors, such as political unrest and scarcity of resources, can lead to a high degree of inflation risk. In some cases, inflationary psychology is a cause of inflation. This is a phenomenon in which consumers invest in precious metal and commodity markets, such as oil and gold, because they are afraid of inflation. By taking money out of the capital markets of stocks, bonds, and other long-term assets, they end up actually creating the inflation they are trying to avoid by raising the value of the commodities and lowering the purchasing power of their money.