DO YOU SEE THINGS clearly when it comes to money? Here’s a test to find out. Which of the following scenarios would you prefer?
- A 5% raise, but the inflation rate is 10%.
- A 3% salary cut, but the inflation rate is 0%.
If you chose the 5% pay raise, you’ve fallen victim to a “money illusion.” This term describes our tendency to view money in nominal terms instead of inflation-adjusted “real” terms.
In the first scenario, you would have 5% more money to spend but you’d be able to buy 5% less in goods and services, thanks to the 10% inflation rate. In the second scenario, your nominal income would be down 3%—and that would also be your loss in purchasing power, because inflation was 0%.
Consider another hypothetical. Say you paid $200,000 in cash for a house 30 years ago. You sell the home for $500,000. Let’s ignore sales commissions, taxes and other expenses. Would you be happy with this investment?
On one hand, you would have made $300,000 on a nominal basis. But if you assume an annual inflation rate of 3%, your $200,000 home should be worth $485,452 after 30 years. On a real basis, you’d only come out $14,548 ahead on the sale. Had you invested the same $200,000 in the stock market, assuming a 7% annualized return, your investment would be worth $1.5 million after 30 years.
The money illusion stems from our view of the dollar as a fixed unit of measurement, like the inch or the mile. In reality, the dollar is a store of value that fluctuates. The value of a dollar in 1982 has shrunken to just 35 cents today. Put differently, a dollar today could only buy a third of the goods and services that it could have bought in 1982.
The money illusion is tricky because we see nominal prices with our eyes. Inflation, by contrast, is sometimes a stealth phenomenon. We might pay the same price for our favorite box of cookies without realizing that there are fewer cookies in the package. We may notice a recent surge in gas prices, but would we notice if the price of chicken rises a few cents per pound next month?
A more recent example of the money illusion comes from the yield on Series I savings bonds. Investors appear gleeful knowing that they can earn an annualized 9.6% yield on I bonds over the next six months. But that’s just the nominal return. The real return—the return after subtracting out inflation—is designed to be zero. Still excited? I am, but only because other fixed income options are lagging inflation.
John is a physician and author of “How to Raise Your Child’s Financial IQ.”