As Inflation Rises, Beware of the Money Illusion. It May Cost You a Lot

People often focus on the actual amount of money they earn or spend, rather than its purchasing power.
Shlomo Benartzi

As inflation rises in the U.S., a blind spot known as the money illusion could lead many people to make serious financial mistakes.

Put simply, the money illusion refers to the fact that people typically tend to think in nominal dollars—the actual amount of money spent or earned—and not real dollars, which is the purchasing power of money after taking inflation into account.

Here is a simple formula, known as the “Rule of 72,” that makes it easy to understand the powerful effects of inflation over time—and how much damage the money illusion can do. Take 72, and divide it by the annual inflation rate. The resulting number tells you how many years it will take to cut your purchasing power in half. For instance, based on August’s core inflation rate of 3.6%, in 20 years (72 divided by 3.6), your current income would buy you only half as much as it does today. That means if you go out to dinner with somebody, the same amount of money that buys you two meals today would buy you only one in 20 years.

To see if you’re at risk from the money illusion, consider the following question, which is adapted from a highly cited paper by Eldar Shafir, Peter Diamond and Amos Tversky. The question goes like this:

Adam, Ben and Carl each received an inheritance of $200,000 and bought a house for that same amount. Each of them sold the house a year after buying it. Economic conditions were different in each case.

  1. When Adam owned the house, there was 25% deflation. A year after Adam bought the house, he sold it for $154,000, which is 23% less than he paid.
  2. When Ben owned the house, prices stayed the same. Ben sold the house for $198,000, or 1% less than he paid for it.
  3. When Carl owned the house, there was a 25% inflation. A year after he bought the house, Carl sold it for $246,000, or 23% more than he paid.

Who got the best deal? Who got the worst deal?

According to the research, the most popular answer is that Carl got the best deal and Adam did the worst. Carl, after all, got highest sales price in nominal dollars.

However, in real dollars, these answers are backward. Carl did the worst—he lost 2% of his money to inflation—and Adam did the best, with a gain of 2%. In fact, Adam was the only one who made a profit in real dollars.

If, like most people, you thought Carl got the best deal, you should be especially careful when making long-term financial decisions right now, as rising inflation can impact every stage of your financial life. Here are some areas where it pays to pause and see if you’re making a decision through the distorted lens of the money illusion.

Homeownership: Say you are looking to buy a home. If you’re worried about inflation, a fixed-rate mortgage might be the best choice. Housing values tend to rise with inflation, but your mortgage payments are fixed, so higher inflation means you end up building equity faster.

Insurance: Review your home-insurance coverage. Suppose that you purchased a home in New York in 2000 and forgot to adjust your home-insurance coverage. If your home was damaged by a recent storm, you would only be able to replace 63% of your current home, given inflation and the rise in construction costs. The same principle applies to long-term care and life insurance. Inflation means it likely will provide far less support today than you had initially assumed.

Investing: Take a look at your portfolio. Some baby boomers, seeking stable income in retirement, may have a big chunk of their portfolio in bonds, thinking these are low-risk investments. Unfortunately, inflation can lead even the safest bonds, such as 10 and 30-year Treasury bonds, to fall in value. For instance, if long-term inflation expectations increase by just 1%, then the price of the 30-year Treasury bonds can fall by 20%. And if you don’t plan to sell your bonds, and thus don’t mind the price fluctuation, future coupon payments also will lose value to inflation. This is the power of inflation—it can turn seemingly safe investments into risky assets.

Saving for retirement: Say you are a 30-year-old worker who plans to retire at age 70. You look at your projected retirement income and feel that $50,000 a year in income would be sufficient. But if that number isn’t adjusted for inflation—and many retirement calculators aren’t—an inflation rate of 3.6% a year (the inflation rate in August ) means that $50,000 would buy you only $12,150 worth of consumption at the time of retirement.

Spending in retirement: Are you considering buying a financial product designed to help retirees deal with future expenses? Many aren’t protected from inflation. Longevity insurance, for example, provides payments to retirees after they turn a certain age in exchange for a lump sum. However, because longevity insurance typically doesn’t take inflation into account, it can leave retirees with reduced purchasing power, especially if they buy the insurance product far in advance. If you buy at 65, and it kicks in at 85, and inflation stays at 3.6%, each future dollar would only buy you half the goods.

More generally, consumers of all ages should look at the effects of inflation on their own household budget, as prices rise at different rates in different categories. If you fail to account for inflation in your financial plans, you’ll almost certainly feel its impact over time. The key is to take action before you feel the pain of rising prices, because once you notice the pain it’s probably too late.

The Wall Street Journal