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Understanding Inflation (and Avoiding) the "Money Illusion" Thumbnail

Understanding Inflation (and Avoiding) the "Money Illusion"

It’s no surprise that a dollar today isn’t worth the same as a dollar was 20 years ago. This is the result of inflation. Inflation plays a major role in financial planning whether you are conscious of it or not.

The money illusion refers to a cognitive bias that fails to take inflation into account. Let’s dive into what the money illusion is, how it can impact your long-term financial planning, and ways to combat the money illusion.

What is the Money Illusion?

According to Seeking Alpha, money illusion (or price illusion) is the tendency to think of your income in nominal values versus real terms.1 When you think of something in nominal terms, you fail to consider external factors such as inflation. 

Nominal value is not the same as real value. For example, if you get a nominal 5% raise at work, but inflation is 7%, you are at a net loss of 2% in terms of real value. Even though your annual income went from let's say $100,000 to $105,000, the $5,000 or 5% pay increase is not enough to sustain your buying power because the cost of living went up by 7%.

There are a few reasons why the money illusion continues to play a role in the way we think about financial planning. The first comes down to a simple lack of financial education. Many people don’t know the rate of inflation or don’t understand how it impacts the real value of their income. 

The second is price stickiness. Price stickiness occurs when goods and services remain the same price despite other economic factors.2 These rigid prices may fog our view of inflation and make it seem like we can buy the same things today as we could in the past for the same amount, even if this isn’t reflective of the overall economy. 

How The Money Illusion May Impact Financial Planning

As you can see, the money illusion is a tricky cognitive bias that, over the course of your long-term financial planning, may put you behind your goals. If you think to yourself that you need $1 million to retire comfortably in today’s real terms, what does that equate to in 10, 20, or 30 years when you are actually ready to retire? You will likely need more than $1 million to retire comfortably as you race inflation. For example, if inflation on average is 2.5% per year, over the next 20 years, then the inflation adjusted value of $1 million will be $1.6 million in 20 years from now. 

How to Combat The Money Illusion

Without acknowledging inflation and the real buying power of your income, you may slowly fall behind on your financial goals. But, by building out a solid financial strategy and understanding our current economy, you can combat the money illusion and understand how much money you actually need to pursue your long-term goals. 

One way to do this is to understand how inflation works and the current rate of inflation. This will help you understand how much you have to make to keep up your buying power. 

Another way to do this is to not make risky financial decisions without understanding the market as a whole. You can work with a financial professional to create an investment plan that hedges against inflation. The average rate of return of the S&P 500 index is about 8% per year3 and the annual rate of inflation in the US hit 6.2% in October 2021.4 This means that your investments may help you minimize the impact of inflation over the long term. Talk to your financial professional about specific strategies that can help combat the money illusion and inflation while preserving the buying power of your money. 

  1. https://seekingalpha.com/article/4206486-money-illusion
  2. https://www.investopedia.com/terms/p/price_stickiness.asp
  3. http://www.moneychimp.com/features/market_cagr.htm
  4. https://www.pewresearch.org/fact-tank/2021/11/24/inflation-has-risen-around-the-world-but-the-u-s-has-seen-one-of-the-biggest-increases/

This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.