What does inflation risk refer to?

Inflation risk specifically refers to the possibility that the purchasing power of money will decrease over time due to rising prices. When inflation occurs, the same amount of money buys fewer goods and services than it did previously. This erosion of buying power impacts individuals and investors, as it can lead to lower returns on investments if those returns do not outpace inflation.

For example, if you have a fixed income investment that yields a 3% return and inflation rises to 4%, the real return on your investment is negative, meaning you are effectively losing money in terms of purchasing power. Understanding inflation risk is crucial for making informed financial decisions, such as choosing investment vehicles that may offer returns designed to outpace inflation, like stocks or real estate.

In contrast, the other options reflect different types of financial risks. Over-investing relates to the allocation of capital in an unstrategic manner, market crash refers to drastic declines in investment values in a short period, and liquidity risk involves the challenge of converting investments into cash quickly. Each of these risks affects financial strategies but does not directly pertain to the loss of money's value over time due to inflation.