Inflation refers to a general increase in the price of all goods and services. Consider that a Mars Bar is 80p now, but when I was a teenager it was 40p. This means that what £1 used to be able to buy you - it’s “spending power” is now not as strong as it used to be 10 years ago. Think about how much you paid for your first home or your first beer and compare it to the cost today, this is the power of inflation.
Inflation is quoted as a percentage increase (or decrease when ‘deflation’ occurs) per year. If wages don’t keep up with rising inflation, the purchasing power of your money and standard of living begins to fall. One of the measures is called the Retail Price Index which is currently 1.5% in the UK. Between 1949 and 2020 the inflation rate of the Retail Price Index fluctuated from a high of 24.2% in 1975 and a low of minus 0.5% in 2009.
But how does inflation risk affect my savings? Holding all your money in cash means that you won’t see the value fall, but, over time the spending power of these savings will fall. If the interest rate on your savings is 0.5% per year and the inflation rate is 1.5% per year, then the spending power of your savings is being gradually reduced over time - a big factor to consider when you have all your assets held in cash.
This is why for long term planning it’s sensible to consider all aspects of risk and ensure you have a diversified portfolio - to try and reduce these risks where possible. Investing can help to solve inflation risk, as you have the potential for a return above inflation - but you have the risk you might receive back less than you invested.