Purchasing power risk is the possibility that you will not be able to buy as much with your savings in the future. It represents a loss of value due to inflation.
What is It?
Purchasing power refers to what you are able to buy with a given sum of money. The risk, then, is that you may be able to buy less with a given sum of money in the future.
Think about this in the context of your savings. When you set aside money for saving and investing you inherently give up buying something with that dollar today, to be able to buy something later. In simple terms, for every $1 you save today that’s $1 less you can spend today, but it gives you $1 more to spend later.
The idea of purchasing power takes this simple fact a step further and asks what that dollar could have bought today, and what it will be able to buy later – whenever “later” is. That’s a logical question since we all recognize that a single dollar won’t go as far in the future.
Although saving is good, and I’m certainly not telling you to stop, it does expose you to the possibility that you could have bought more today than what you will be able to buy in the future if your purchasing power falls.
What Causes Purchasing Power to Decline?
Your purchasing power declines due to inflation. Inflation is the gradual increase in prices over time. Since prices tend to rise over time, a single dollar buys less over time.
Here’s where we can consider the classic comparison of a can of coke through time. A can of coke is just a can of coke, but if you paid for it in 1930, 1950, 1975, 1990, or 2020 it will have a very different price. The price of one gallon of gasoline is another classic example. Think back to their prices when you were a kid and compare them to the prices now.
The higher the rate of inflation, the more things cost over time, and the more purchasing power you lose.
Here is a look at historical rates of inflation over time from the St. Louis FED:
Notice that inflation varies, sometimes by a lot, but you don’t need to worry about beating inflation each and every year. You just need to beat it on average.
How Do I Avoid Purchasing Power Risk?
The only way to avoid purchasing power risk is to not save anything. If you save, then you are exposed to purchasing power risk.
That’s really not a good financial strategy though.
Instead of avoiding purchasing power risk, it’s better to manage it. To manage your purchasing power risk, you need to invest in such a way that you can expect to “beat” inflation with the returns you’ll earn.
As long as you are willing to take a moderate amount of risk when choosing your asset allocation that isn’t typically hard to do, especially over long investment time horizons.
For example, if your portfolio provides a 6% return in a year when inflation is 3% then you have beat the decline in purchasing power.
Going back to our $1, let’s consider the coke example. Say the $1 can buy a coke this year, but inflation is 3%, so it takes $1.03 to buy the coke next year. If you earned 6% on that dollar then you now have $1.06 and can still buy the coke.
If you had simply let the $1 sit there, you’d only have $1 and would not be able to buy the coke.
Keep in mind you don’t need to beat inflation each and every year. You need to beat average inflation over the long term.
Future Purchasing Power – Your Real Rate of Return
A simple check you can do to see how much purchasing power risk affects you is to find the future value of your savings using your real rate of return.
You can approximate your expected real rate of return by simply subtracting the expected average rate of inflation from your expected average rate of return.
- You invest in a mix of stocks and bonds that you believe will give you an average return of 9% each year.
- You also expect inflation will average 3% per year going forward.
- Your real, or inflation-adjusted, rate of return is 6%.
The amount that you calculate using a real rate of return represents the buying power of your savings in the future. Your actual (nominal) savings will be higher, but that doesn’t help you understand buying power.
When calculated this way, you can understand your future purchasing power by answering the question “What can I buy with that sum of money today?”