Researchers at University of Chicago in the US conducted a long-term study of nearly 3,000 adults, aged 57 to 85 years.
They found that those who could not identify at least four out of five common odours - peppermint, fish, orange, rose and leather - were more than twice as likely to develop dementia within five years.
The team found that although 78 per cent of those tested were normal - correctly identifying at least four out of five scents - about 14 per cent could name just three out of five.
Researchers noted five years after the initial test, almost all of the study subjects who were unable to name a single scent had been diagnosed with dementia.
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Nearly 80 per cent of those who provided only one or two correct answers also had dementia, with a dose-dependent relationship between degree of smell loss and incidence of dementia.
"Loss of the sense of smell is a strong signal that something has gone wrong and significant damage has been done," said Jayant M Pinto, professor at the University of Chicago.
These look like a felt-tip pen, but instead of ink, they are infused with distinct scents. Study subjects smell each item and are asked to identify that odour, one at a time, from a set of four choices.
The five odours, in order of increasing difficulty, were peppermint, fish, orange, rose and leather.
Researchers noted that 78.1 per cent of those examined had a normal sense of smell, 48.7 per cent correctly identified five out of five odours and 29.4 per cent identified four out of five.
The olfactory nerve is the only cranial nerve directly exposed to the environment, researchers said.
The cells that detect smells connect directly with the olfactory bulb at the base of the brain, potentially exposing the central nervous system to environmental hazards such as pollution or pathogens. Olfactory deficits are often an early sign of Parkinson's or Alzheimer's disease.
They get worse with disease progression, researchers said.