How Inflation Reduces Investment Returns
Your savings account might show 5% growth this year, but if inflation is running at 3.5%, your real gain in purchasing power is less than 2%. Here's how to think about real returns.
What is inflation and why does it matter for savers?
Inflation is the rate at which the general level of prices rises over time. A basket of goods costing £100 today costs £103 in a year if inflation is 3%. This means money loses purchasing power over time — a pound tomorrow buys less than a pound today.
For savers and investors, inflation creates a critical distinction between nominal returns (the face-value percentage your investment grew) and real returns (the actual increase in purchasing power after accounting for inflation).
The Fisher equation
The accurate formula for real return is:
For low rates, you can approximate with: Real rate ≈ Nominal rate − Inflation rate. At higher rates, the Fisher equation is more accurate.
Real examples of inflation eroding returns
| Nominal Return | Inflation Rate | Real Return | Verdict |
|---|---|---|---|
| 2% | 3% | −0.97% | Losing purchasing power |
| 4% | 3% | 0.97% | Barely ahead of inflation |
| 7% | 2.5% | 4.39% | Genuine real growth |
| 10% | 5% | 4.76% | Strong real growth despite high inflation |
Cash savings often lose to inflation
During periods when central banks hold interest rates low, cash savings accounts frequently earn less than the inflation rate. In such periods, every year you hold cash, your purchasing power declines in real terms — even as your account balance nominally grows. This is sometimes called a "stealth tax" on savers.
How to build a portfolio that beats inflation
- Equities (stocks): Historically the most reliable long-term inflation beaters. Company revenues and profits tend to grow with inflation over time.
- Index-linked bonds: Some government bonds adjust their value with inflation, providing direct inflation protection.
- Real assets: Property, infrastructure, and commodities have historically tracked inflation reasonably well.
- High-rate savings accounts: When rates are competitive, locking in a fixed rate above current inflation provides short-term protection.
Calculate your real return
Use our Inflation-Adjusted Returns Calculator to see the real purchasing power of your future investments.