What is meant by "inflation risk"?

Inflation risk refers to the possibility that the purchasing power of money will decline over time due to rising prices. When inflation occurs, each unit of currency buys fewer goods and services than it did previously, which effectively reduces the real value of returns on investments. Choosing option C highlights this concept accurately, as it acknowledges that even if an investment generates nominal gains, those gains may not keep pace with inflation, resulting in a decrease in the investor's real wealth.

Understanding inflation risk is crucial for investors because it affects various asset classes differently. For instance, fixed income investments like bonds may struggle to keep pace with inflation, while certain equities might offer better long-term growth potential. Therefore, recognizing the impact of inflation on returns helps investors make informed decisions about maintaining their purchasing power across their investment horizon.

In contrast, the other options address different financial risks that do not directly relate to the erosion of purchasing power due to inflation. The risk of losing principal investment value pertains to market volatility or credit risk, the chance that interest rates will rise relates to interest rate risk, and fluctuations in stock prices due to market sentiment describe volatility risk. Each of these elements is important in the broader spectrum of investment risk but does not specifically encapsulate the essence of inflation risk.