Finally purchasing power risk
. In nearly every year, inflation causes the pound to purchase less than it did before.
Financial risk tends to increase as an investor adds more own-type investments to his "rate of return matrix" (portfolio), but purchasing power risk tends to decrease (assuming the potential return is in fact realized).
Diversification to reduce both financial and purchasing power risk is the obvious answer; the investor must mix the investments in his portfolio to defend against these two risks, or risk the consequences in return for the potential rewards.
McCandless observes, however, that the market risk tied to exposure to equities has to be balanced against the purchasing power risk
associated with fixed income securities (i.e., the risk of earning a rate of return that is below the rate of inflation).
As noted, however, money market investments are subject to maximum purchasing power risk. Longer-term fixed income investments, such as U.S.
Even if they choose to leave their funds in the bank or invest all of their money in Treasury bills, they will face serious purchasing power risks since these types of investments generally fail to keep pace with inflation on an after-tax return basis.
Every investment has some risk, even if it is only purchasing power risk
. Indeed, one of the best questions to ask an investment adviser is, "What's the risk in this investment?" He should answer the question directly and intelligently.
Stulz (1984) expands the literature on exchange rate determinants by investigating the effect of purchasing power risks
on exchange rates.