Why is understanding inflation important for investors?

Understanding inflation is important for investors primarily because it is crucial for assessing real returns on investments. Real returns reflect the actual purchasing power of the income generated from investments after adjusting for inflation. For example, if an investment earns a nominal return of 5% and inflation is 3%, the real return is only 2%. This means that, although the investment appears to be growing in nominal terms, its actual value in terms of purchasing power is not increasing significantly.

By factoring in inflation, investors can make more informed decisions about where to allocate their capital, as they can understand how inflation erodes the value of their returns over time. This understanding helps in selecting investments that are likely to outpace inflation and contribute to long-term financial goals. Knowing the impact of inflation allows investors to plan and strategize their portfolios effectively, ensuring they maintain or enhance their position in the market over time.