Understanding (and Avoiding) the "Money Illusion"
Leisl L. Cording, CFP®
Senior Vice President & Financial Advisor
It’s no surprise that a dollar today isn’t worth the same as a dollar was 20 years ago (or even last year, for that matter). This is the result of inflation, which plays a major role in financial planning whether you are conscious of it or not.
The money illusion refers to a cognitive bias where one’s thinking and planning fails to take inflation into account. Here’s how that one mistake can impact your long-term financial planning, and how to avoid making it so you arrive at the reality you’d planned for yourself years from now, instead of coming up far short.
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 nominal value of two cars might be the exact same because they cost the same to manufacture. But if one car later becomes a highly collectible classic, the real value of that car will be much higher than the other. 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.
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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 against inflation. (Here’s a tip – you can get a great idea of what you’ll actually need by using our interactive financial calculators.)
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. 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 end up being more expensive than advertised.
- Lastly, you can work with a financial advisor to create an investment plan that hedges against inflation. The average rate of return of the S&P 500 index is about 8% per year.3 Although the US inflation rate is near a 40-year high right now at 8.5%, the overall average annual inflation rate during that time has been about 2.8%. This means that your investments may help you minimize the impact of inflation over the long term.
Feel free to reach out to us at Weiss, Hale & Zahansky Strategic Wealth Advisors to talk about specific strategies that can help you to combat the money illusion and inflation. Our strategic Plan Well, Invest Well, Live Well process is designed to maximize your finances both in the short-term and over the long-term, so you can Live Well while also fearlessly pursuing your goals for the future.
Presented by Senior Vice President, Financial Advisor, Leisl L. Cording CFP®. Securities and advisory services offered through Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. These materials are general in nature and do not address your specific situation. For your specific investment needs, please discuss your individual circumstances with your financial advisor. Weiss, Hale & Zahansky Strategic Wealth Advisors does not provide tax or legal advice, and nothing in the accompanying pages should be construed as specific tax or legal advice. 697 Pomfret Street, Pomfret Center, CT 06259, 860.928.2341. http://www.whzwealth.com
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