Money Illusion Bias

Money Illusion Bias

Time For Reflection

Let's look at a hypothetical scenario

Looking back at our investments which yielded us say,  a certain x% of returns, don't we all feel happy about getting a bit richer with that ROI - an additional x% of what we initially invested ?

Let's do a reality check - During the period when our investment increased by x%, the inflation also increased by, say (x+1)% .  Now, the question is - If we factor in the inflation, did we calculate the  profit on our initial investment correctly? The answer would be NO, because the accrued amount (of my initial investment) does not hold the same purchasing value as my initial investment at that point in time and i may not be able to buy as much as i could with my (invested) money earlier !

This exactly is what "money illusion bias" does to us in reality. We forget to factor in the inflation factor and end up calculating the return on out investments incorrectly.

Definition and Background

Money Illusion Bias refers to the tendency of people to think of money in terms of nominal value (face value) rather than real value (purchasing power). Here, nominal value refers to the price expressed in money of the day and real value refers to the price which adjusts for the effect of inflation.   

The bias happens when the numerical/ face value of money is mistaken for its purchasing power(real value) and the increased nominal amount of money creates the illusion that we have become wealthier. 

The term "Money Illusion" was coined by Irving Fisher in 1920s and he also wrote a book titled "The Money Illusion" in 1928, where he clearly defined the problem that many people think in terms of nominal values instead of real values, or as the case may be, in a mix of the two. The concept of money illusion was popularised by John Maynard Keynes.

Why/ How Does Money Illusion occur ?

The "Money Illusion" occurs because a particular amount of money, at a specific point of time, is not not worth the same amount today. The main reason is because of the effect of inflation. 

When some nominal income increases, it can generate the mistaken feeling of purchasing power having gone up, when in fact, monetary erosion due to inflation may be decreasing the purchasing power in real terms 

More About Money Illusion

The concept of Money Illusion can be understood with this quote by Warren Buffet - 

"It is not how many dollars you have, but how many cheeseburgers you can buy. In other words, if stocks double but so does the price of milk, gas and cornflakes, you haven't actually gained anything in real net worth."

Eldar Shafir, Peter A. Diamond and Amor Tversky (1997)  have provided empirical evidence for the existence of Money Illusion Effect, and it has been shown to affect behaviour in a variety of experimental and real-world situations.

Shafir et al. also state that money illusion influences economic behaviour in 3 main ways which are as mentioned below :

• Price Stickiness - Nominal prices are slow to change even when inflation causes real prices or costs to rise.

• Contracts and Laws are not indexed to inflation as much as one would rationally expect

• Social disclosure, in formal media and more generally, reflects some confusion regarding real and nominal value. 

The "Money Illusion" influences people's perceptions of outcomes. Experiments have shown that people generally perceive an approximate 2% cut in nominal value with no change in monetary value as unfair, whereas, a rise of 2% in nominal value where there's a 4% inflation as fair, despite them being almost rational equivalents. Also, in money illusion, nominal changes in price can influence demand even if real prices have remained constant. 

Many economists contend that money illusion does not exist and people act rationally i.e. they think in terms of real value, by accounting for inflation/ deflation, with regard to their money 

The presence of Money Illusion could be seen in areas like Wages/ Salary, Housing, Stocks/ Bonds and any cash flow including dividends and interest. more. Talking about the impact of Money Illusion, it it could lead to 

• underestimation of the need to save
• sharp reduction in purchasing power
• poor economic choices
• inaccurate view of prices and costs

Though there is no easy solution for the money illusion bias and the most we can do is to adjust any nominal value increase with respect to the inflation.

"Investment adjusted with Inflation" is the best antidote to "Money Illusion"