The term “money illusion” refers to a tendency to think in terms of nominal rather than real monetary values. In other words, one mistakes the face value of the money (nominal value) as its purchasing power (real value). That’s what we do with money, purchase things, right? So, people who fall for this illusion seem to ignore or fail to understand the purchasing power of their money and simply anchor on the nominal value. This, along with a natural bias towards using “nominal” values for evaluation, can influence actions and decisions that result in potentially catastrophic results on financial well being. This illusion is very complicated, has many forms, and is frequently manipulated by government and business entities worldwide.

Inflation is when the supply of available money increases and the purchasing power of the money already in circulation decreases. If your wages and investments increase proportionately, then the loss in purchasing power may be offset. However, many times individuals hold assets in various forms that seem to be safe but have little potential for holding their purchasing power. A good example is cash and cash equivalents that have little chance of adjusting to inflation and therefore are effectively reduced in value. To a degree, this affects lower and middle class families more than the wealthy because they tend to hold a larger percentage of their total assets in cash. As these families enter retirement a greater percentage is dependent on fixed incomes, wages, or pensions that also might be subject to the adverse effects of inflation.

Ah ha ….your catching on to why governments love to use the “nominal” illusion!

And it doesn’t stop with the government; many other aspects of our financial lives are not indexed to inflation. Here’s just a few examples, labor contracts, insurance contracts, fixed mortgages, fixed annuities, among many, many more. What about your annual pay raise? Why would people balk at a cut in income during a recession, but accept a 2% raise during periods of 4% inflation?

A common or “catch all” approach to understanding, filtering, and factoring money illusions into investment strategies for individuals is tough because no two investors are the same. Chances for successful strategies become even less viable when the client and advisor fail to correctly identify all of the risks at hand or allow money illusions to cloud viewpoints.