Interest Rate, Inflation, and Currency Risk

Why this matters

The last lesson's risks came from businesses and markets. These three come from the wider economy, and they affect investments that look perfectly safe. A US Treasury bond is generally treated as having very low credit risk, and can still lose a fifth of its value in a year. Cash never falls in dollars, and can still lose buying power every year.

Interest rate risk

Interest rate risk is the risk that changes in interest rates lower an investment's value. For bonds, the SEC explains it simply: when rates rise, newly issued bonds pay more, so older bonds with lower rates may have to be sold at a discount. If you hold a bond to maturity, you get its face value back; if you sell earlier, it may be worth more or less.¹

The effect is bigger for longer-term bonds, as Part 2's Duration and the Yield Curve showed. In 2022, as rates rose sharply, 10-year US Treasury bonds lost about 18% including interest, their worst year in Damodaran's data going back to 1928.²

Stocks are affected too, more indirectly. Higher rates mean safer investments pay more, and future profits are worth less in today's money, as Part 4's Time Value of Money and Discount Rates explained. In 2022, the S&P 500 lost about 18% as well.²

What softens it: matching bond maturities to when you'll need the money, so you can hold to maturity, and remembering that falling bond prices also mean higher yields on new purchases.

Inflation risk

Inflation risk is the risk that rising prices erode what your money can buy. The SEC notes it's a particular risk for investors receiving a fixed rate of interest, and the main concern for money held in cash equivalents.¹

If prices rise 3% a year, something that costs $100 today costs $100 × 1.03²⁵ ≈ $209 in 25 years. Money kept as cash and earning nothing would buy about 48% of what it buys today: less than half. Even cash that earns interest loses ground in any year when inflation is higher than its interest rate. The 3% rate is hypothetical.

What softens it: owning assets whose income and value can grow over time, such as stocks, for long-term money, and inflation-protected bonds like the ones in Part 2's Inflation-Protected Bonds: TIPS and I Bonds. Cash remains the right home for short-term money, despite this risk, because its value doesn't swing.

The rest of this lesson is for members

Still to come in this lesson: Currency risk, the key takeaways, and 2 quiz questions with explanations.

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