Understanding (and Avoiding) the "Money Illusion"
Inflation... perhaps one of the bigger questions on investors' minds are about inflation. How high will it go and how long will it last? 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. As a Financial Advisor in Murfreesboro, TN, inflation is taken into consideration when investing and planning for clients' future to prevent the "money illusion."
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, the real value of two shirts might be the exact same because they cost the same to manufacture, but one might sell at a higher price point due to demand, marketing, reputation, and brand name. These external factors contribute to the real cost of the shirt.
The same is true for your money. If you get a 5% raise at work, but inflation is 7%, you are at a net loss of 2% in terms of real value.
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 color 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? Taking inflation into account may prove that you need more than the originally planned $1 million for retirement.
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, which will help you understand how much you have to make to keep up your buying power. The annual inflation rate in the US accelerated to 8.5% in March of 2022, the highest since December of 1981. Whether you're experiencing price increases in the grocery store or purchasing a vehicle, it's often painful to experience at that level. It's important to remember that the current heightened pace of inflation won't last forever. However, over time, we do experience inflation, and it must be factored into our planning.
Another way to do this is to not make risky financial decisions without understanding the market as a whole. As we talked about, price stickiness might be deceiving when you look at what you can afford. Sure, you might be able to afford a new home or car, but with rising rates of inflation that item might be more expensive than it’s advertised.
Lastly, partner with a Financial Advisor who can help you navigate these external factors and how they may impact our future. We often have conversations with those worried about the impact of inflation on portfolios. Historically, even during times of higher inflation, stocks and bonds have generally provided solid returns. It’s mostly at the extremes — when inflation is above 6% or negative — that financial assets have tended to struggle. 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. Contact us to talk about specific strategies that can help combat the money illusion and inflation and keep you on track to a bright future.
- https://seekingalpha.com/article/4206486-money-illusion
- https://www.investopedia.com/terms/p/price_stickiness.asp
- http://www.moneychimp.com/features/market_cagr.htm
- 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.
