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Understanding (and Avoiding) the "Money Illusion" (A 90-second read!)

  1. It’s no surprise that today’s dollar isn’t worth the same as the dollar 20 years ago. This is the result of inflation, and inflation plays a major role in financial planning. The “money illusion” refers to a cognitive bias that fails to take inflation into account. Let’s investigate what the “money illusion” is, how it can impact our long-term financial planning, and ways we can combat it.

    The money illusion is a tendency to think of our income in nominal values vs. real terms. When we think of something in nominal terms, we look at the price on the front of the paper. When we only do this, we fail to consider external factors such as inflation. 

     There are a few reasons why the money illusion plays a role in the way we think about financial planning. The first comes down to a simple lack of financial knowledge. The second is “price stickiness,” which occurs when goods and services remain the same price, despite other economic factors. These rigid prices may influence 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. 

    If we think that we need $1 million to retire comfortably in today’s terms, what does that equate to in 10, 20, or 30 years when we are ready to retire? Without acknowledging inflation and the real buying power of our income, we may slowly fall behind on our financial goals. However, by having a solid financial strategy and understanding our current economy, we can combat the money illusion and understand how much money we need to pursue our long-term goals. 

    One way to do this is to keep up on the current rate of inflation and to understand how inflation works. Another way is to refrain from making risky financial decisions without understanding the market and how it truly affects our financial health. We might be able to afford a new home or car, but with rising rates of inflation that item might be more expensive than we realize. 

    Understanding the “Money Illusion” can go a long way in helping us prepare for our future.