Let me explain. If you have a portfolio with $100,000 in certificates of deposit earning 4.5% interest per year, resulting in $4,500 in interest income annually. You are in the 25% tax bracket so you pay $1,125 to the Federal government in taxes, leaving $3,375 in interest income for you. What was your profit for the year? Was it $3,375, or 3.375%? No! The truth is you cannot answer that question honestly until you discover what the rate of inflation was over the same period you earned your interest income.
The rate of inflation, as you may already know, refers to the loss of purchasing power. Sometimes, the rate of inflation increases because the government prints more money than it should so each dollar becomes worth less than it was last year. Other times, the rate of inflation increases because increased demand for a fixed supply of goods drives up prices. This has been evident in copper prices for the past decade as nations like China and India have industrialized, resulting in billions of people requiring copper, and being willing to pay for it, to function in their day-to-day lives. Many times, the rate of inflation is influenced by both of these factors.
Going back to our hypothetical portfolio, what if the rate of inflation for the year had run 4%, which was the average for the century between 1900 and 2000? Then you would have lost $625, or 0.625% of your purchasing power! You didn't make any money even though you have $3,375 more in cash in the bank. It is an illusion. It isn't real. You can buy less milk, cheese, eggs, butter, gasoline, heating oil, clothing, and real estate than you could last year!
One of the best books in history on how the rate of inflation can destroy your wealth was written in 1928 by economist Irving Fisher. It was called "The Money Illusion". Fisher was a professor of economics at Yale University. He was fascinated with the notion that average people simply could not see nor understand that if they receive a pay increase of 3% in a year, but the cost of living increases 5% over that same period of time, they are really 2% poorer. On the other hand, if they received a pay cut of 5%, but their cost of living fell by 7%, they are really 2% richer. This inability to think rationally causes a lot of human misery and explains, in part, why governments err on the side of inflation rather than deflation.
How you can take action in your own portfolio: Look up the consumer price index, or CPI, inflation rate if you live in the United States. Do this at the end of every year. Apply the rate to your pay increases, your portfolio gains, and other income. Then, you can see how much you "really" earned in terms of purchasing power. How many more cheeseburgers, or cars, or pounds of coffee can you buy now than you could last year? This behavior should help you build wealth faster because you won't delude yourself into thinking you are making money when you are really growing poorer.