What effect does inflation have on investment returns?

Inflation reduces the purchasing power of money, which directly affects investment returns. When inflation rises, the value of currency declines, meaning that the same amount of money will buy fewer goods and services in the future than it does today. For investors, this is particularly significant because nominal returns on investments may appear higher; however, when adjusted for inflation, the real returns—the actual increase in purchasing power—are often much lower.

For example, if an investment yields a nominal return of 5% in a year during which inflation is 3%, the real return is only 2%. This emphasizes that while an investment may seem profitable in nominal terms, the erosion of purchasing power due to inflation can diminish the actual gains realized by the investor.

Understanding this relationship is crucial for making informed financial decisions, as it helps investors to recognize the importance of considering inflation in their return expectations.