We all know about inflation, but how many of us factor inflation into our long-term investment expectations? Here's chart of the S&P Composite going back to 1871 with no inflation adjustment.

Now here's the same chart corrected for inflation. Economists would say the first shows "nominal" prices, the second "real" prices. If you study the two in alternation, you notice some striking differences.

But when you combine the two into a single chart, you instantly see what I call the Unreal Price Differential. From the 1871 to World War II, the occasional episodes of deflation kept nominal and real stock prices relatively aligned. After WWII, inflation has given nominal prices the illusion of superior long-term performance. However, when adjusted for inflation, post WWII prices are shown to be far less outstanding.

About those regression lines
The regression lines (exponential regressions on these semi-log charts) give us mathematically precise slopes representing price growth over the entire 137-year time frame. For nominal prices, the slope is 4.2%. For real prices, the slope is a mere 1.7%. Thus inflation accounts for the majority, 2.5%, of the apparent price appreciation.

New: I've now added a similar analysis of the Dow since 1900. The Dow nominal slope has a 4.9% annualized increase; the real slope has a 1.75% annualized increase. Inflation accounts for the 3.15% differential.

Of course, these numbers exclude dividends, which I'll incorporate into this analysis in the next update.