We live in an uncertain world, with one consequence being that there is no such thing as a risk-free investment. No matter where we choose to invest our assets, they will be exposed to financial risk in one form or another. Hoarding our life savings under a mattress, for example, will expose us not only to the risk of loss due to fire or theft, but also to the risk of loss due to inflation, because the purchasing power of our savings will likely decrease over time.
An investor, aware that inflation can erode his wealth, who seeks to earn a positive return by investing in an asset faces other, less obvious, hazards. While an investment that he could make in domestic government securities will pay a return that may, although is by no means guaranteed to, exceed the rate of inflation, so preserving or increasing his purchasing power, there is a very real, even if small in developed economies, chance that a given government will abrogate its obligations and pay none, or only a portion, of the promised return on its securities. Investors eyeing the credit markets in Europe at the end of 2010, for example, were particularly aware of this possibility, with credit default spreads reflecting a great deal of market unease and uncertainty. One lesson of the recent financial crisis is that what may to the unwary appear to be a conservative and secure investment may, in reality, be like the proverbial wolf in sheep's clothing, exposing the investor to very real ...