The field of play
Not just the unsophisticated
If I look in the most recent edition of The Economist magazine it will tell me that since December 31, 2021, the S&P 500 is down 16.5%. This is in U.S. dollars. Most investors know this roughly. They read it in their local business newspaper or in the Wall Street Journal.
But the 16.5% is an illusion. The real figure is closer to 22.9%. The 16.5% is in nominal terms. The 22.5% is adjusted for the fact that the dollar is worth about 6.4% less today than it was on January 1, 2022.
This propensity to think in nominal terms is a ubiquitous human foible.
More than a curiosity
When I look at my investment performance over the years, I have to be careful to look at real returns, not nominal returns. Since I started investing for our family’s retirement, inflation has eaten away about 4% of our nominal returns each year. The same is true for the price of bread and what our house might sell for. It’s understandable because it’s all priced in money which has no fixed value. Sometimes the real value of something changes. But often a price change is simply because the value of money has changed. We have to work hard to get this through our thick skulls.
For investors, it’s not just about looking at real vs nominal returns. Central to investing in the common shares of companies is the ability of investors to assess the future economic prospects of a business we want to invest in. This includes knowing how it can cope with inflation. And particularly whether in our view, company management or the company’s business model are susceptible to potential problems caused by inflation or by the money illusion itself. As well, it comes up in thinking about future cash flows (real or nominal) and discount rates (real or nominal) for purposes of assessing the fair value of a stock.
Another example would be around the question whether to invest a lump sum of money or pay down a mortgage. This is susceptible to mistakes of money illusion. Bond investors are particularly susceptible to money illusions mistakes.
I suspect that the money illusion contributes to the so-called equity premium puzzle. Finance types have suggested that the historical return on stocks is higher than it should be in relation to risk free treasury bills. Treasury bill investors may not properly assess inflation risks in pricing treasury bills. Stock investors may underestimate the ability of companies to hedge inflation. I say money illusion may contribute. Other explanations have been put forward for the equity premium puzzle, such as asymmetric loss aversion and so forth.
The same sort of illusion occurs in employment situations. An employer might give their staff a 2% or 3%. The employees might be happy. But they will not have counted on the fact that with inflation of, say 4%, they are actually worse off.
Money illusion is actually an important element in modern finance and economics. Money illusion drives a lot of behavior in business, finance and macroeconomics. Let’s take a brief peek at the modern fields of behavioral economics and behavioral finance.
George Akerlof is a Professor of Economics at the University of California in Berkley. He won a Nobel Prize in 2001. In 2009 he co-authored with Robert Shiller (who won a Noble prize in 2013), of a book titled Animal Spirits. One of the key themes in the book is about how businesspeople and investors make decisions with fundamental uncertainty about the future.
Akerlof and Shiller explain that there are a number of aspects to animal spirits and “how they affect economic decisions – confidence, fairness, corruption and antisocial behavior, money illusion and stories.” (emphasis added)
They write that: “The cornerstone of our theory is confidence and the feedback mechanism between it and the economy that amplify disturbances.” And, particularly for our purposes, in explaining how “financial prices and corporate investments are so volatile.” (Akerlof & Shiller, 2009) p.6.
A little history
Investopia notes: “The term money illusion was first coined by American economist Irving Fisher in his book “Stabilizing the Dollar.” Fisher later wrote an entire book dedicated to the topic in 1928, titled “The Money Illusion.” British economist John Maynard Keynes is credited with helping to popularize the term.”
Fisher defined it as ‘failure to perceive that the dollar, or any other unit of money, expands or shrinks in value’ (1928, p. 4).
Peter Howitt, in his book Money Illusion, tells us: “To Fisher, money illusion was an important factor in business-cycle fluctuations. Rising prices during the upswing would stimulate investment demand and induce business firms to increase their borrowing, thus causing a rise in the nominal rate of interest. Lenders would accommodate them by increasing their savings in response to the rise in the nominal rate, not taking into account that, because of the rise in inflation, the real rate of interest had not risen but had actually fallen (Fisher, 1922, esp. ch. 4).” (Emphasis added) See Peter Howitt
The impact of money illusion is ubiquitous. It seems to affect businesses, lenders, government policy makers and investors. Central banks seem to be wise to the problem. For example, they seem to use the impact of money illusion in labour markets in setting monetary policy. Money illusion is said to be one of the reasons central banks are now targeting the establishment and maintenance of inflation at about 2%.
For the last ten years, at least, inflation has been too low. There was a serious risk of deflation, which is much worse for the economy than modest inflation. Central bankers would be delighted if the current round of monetary tightening leads to inflation of about 2%. What that would mean is that the value of money would be eroding at a rate of 2% a year. Actors in the economy would be free to engage in money illusion.
Where understanding money illusion is most important for investors is in making asset allocation decisions (stocks vs bonds), in personal finance decisions (pay down the mortgage or invest the money) and in assessing the future economic prospects of a business we want to invest in (how the business will do in an inflationary environment) and in determining fair value with nominal or real inputs.
Money illusion is real. It is not just the unsophisticated who fall prey to it. Investors would be wise to understand inflation and how money illusion affects our investing activities.
Readers wanting to dig further into the topic of inflation might check out these posts:
Other posts on investment psychology
This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.
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