Do you know what the money illusion is? Here's how to identify and avoid it

Do you know what the money illusion is? Here's how to identify and avoid it

February 08, 2022

What's the best way to ensure you have a comfortable retirement? One essential step is understanding and avoiding the pitfalls of the money illusion. This powerful mental quirk can cause people to make poor financial decisions that can cost them dearly in the long run. 

Even if you're nearing retirement, it's crucial to be aware of this concept and take steps to avoid it. Don't worry; we're here to help! In this post, we'll explain what the money illusion is and how it can impact your investment portfolio. This is essential for investors of all ages. Plus, we'll share some tips for ensuring your finances are on track for retirement. Let's get started!

What is the money illusion?

The money illusion refers to the tendency of people to think about nominal amounts of money rather than their real, inflation-adjusted value. While this mental shortcut can be helpful in some situations – like when you're buying lunch – it can be harmful for investors because it causes them to ignore the impact that inflation has on the long-term purchasing power of their money.

People sometimes fall prey to the money illusion by not understanding how inflation can affect their finances. They fail to realize that ongoing inflation will cause their future dollars to be worth less than present dollars, which means they need more of them to have the same real value as today's.

Inflation also decreases the power of money while you are working. Even if you get a promotion or raise, inflation-adjusted income likely won't change by very much. The result is that people think they're earning more, but their standard of living in real terms isn't increasing. For example, say you buy a new shirt for $20 today and inflation is 3%. Assuming it doesn't go up over the next year, you'll need $20.60 to buy the exact same shirt next year.

What is price stickiness?

Price stickiness is another contributing factor in the money illusion. Many merchants have a hard time adjusting their prices to reflect inflation, so they continue to sell products and services with prices set at levels from previous years. As a result, these numbers appear affordable even when they're not. This leads many people to miss out on investments that could help them meet their financial goals – or to underestimate how much they'll need for retirement because they misjudge the current market conditions.

Investors should always think about finances in real terms to thwart the money illusion. Consider how inflation impacts spending power. Talk with your financial advisor about how your portfolio's purchasing power changes over time. This will allow you to see how inflation will affect the value of your money and influences your future spending and savings plans.

Why is it important to be aware of the money illusion?

Many investors are unaware they are suffering from the money illusion. The money illusion can cause people to make poor decisions, resulting in a significant dent in their investment portfolios. In fact, according to recent research from the world of neuropsychology, when individuals think in nominal rather than real terms, they are more inclined to make harmful financial choices.

For example, many people buy stocks when the market is rising and sell them when a bear market (recession) starts or continues. The problem with this approach is that it doesn't account for the real impact of inflation and consequent decreases in purchasing power.

Another example: Say you're trying to decide between two mutual funds: one has a 1% expense ratio, while the other has a 2% expense ratio. At first glance, the fund with the lower expense ratio seems like the better choice, but this doesn't account for inflation's effect on your investments.

In fact, a 2% expense ratio might be better than a 1% expense ratio if it the returns are consistently higher than the 1% difference in expense ratios.

The money illusion can also be incredibly dangerous for your retirement savings. For instance, say you're trying to decide whether you should retire at 62 or 65. These might seem like small decisions, but they can have a big impact on what you'll actually spend each year in retirement and how long your money will last.

Don't ignore inflation when planning for your future

To make good decisions about your retirement, you need to consider the rising cost of living due to inflation and adjust your spending plan. In other words, you need to think about what your money will buy in the future.

Although it's possible that a couple can get by on $40,000 a year in today's dollars during retirement, that money might only be able to buy them half the life they were expecting. An average 65-year old couple may need over $72 000 a year in real terms to maintain their current standard of living.

How to identify if you're experiencing the money illusion

To determine whether or not you're affected, look at how much purchasing power your savings and investments have today. Then, estimate how your spending habits might change in the future (including healthcare-related costs), and consider what they will buy compared to today. If they seem like they won't go as far as you hope, it's time to make some adjustments.

Avoiding the money illusion altogether can be challenging. We live in a world that deals with numbers on a daily basis and often at face value. But understanding the difference between nominal and real prices can help you make better purchasing decisions and avoid many common financial traps.

The bottom line

If you want to know more about how inflation affects your investments, check out our blog post on the annual Cost-Of-Living Adjustment (COLA) and what it means for your Social Security. And if it's time for you to plan for retirement or update your investment strategy, don't hesitate to give us a call. Remember, your local fee only planner provides an important perspective that is always in your best interests, so you can be assured that the advice you're getting will help you to make the most of your retirement savings.