What does "inflation risk" mean?

Inflation risk refers specifically to the possibility that the returns on an investment will not outpace the rate of inflation, leading to a decrease in the real purchasing power of the returns over time. This means that even if an investment seems to be generating positive returns, if those returns are lower than the inflation rate, the investor may find themselves at a disadvantage.

For instance, if an investment yields a return of 3% but the inflation rate is 4%, the real return is effectively -1%, indicating a loss of purchasing power. This concept is critical for investors to understand, as it directly impacts the long-term value of their investments and their financial goals.

Other options relate to different types of risks. The risk related to economic downturns addresses market risk, while uncertainty surrounding interest rates pertains largely to interest rate risk. Fluctuating currency exchange rates involve currency risk, especially relevant for investors dealing in foreign assets. Each of these risks plays an important role in investing, but they do not specifically address the concern of the erosion of investment returns due to inflation, which is encapsulated under inflation risk.