Money Illusion is the sneaky cognitive bias that causes people to think about money in nominal value (the face value on the banknote) rather than real value (what that money can actually buy). In simple terms, it's our brain's tendency to ignore the silent, wealth-eroding effects of inflation. We see more dollars in our account and feel richer, even if the purchasing power of each dollar has shrunk. This mental shortcut, first detailed by economist Irving Fisher and later popularized by John Maynard Keynes, makes us focus on the numbers on a screen or a paycheck, rather than the real-world value they represent. For an investor, falling for this illusion is like trying to navigate a ship by looking at a map without a compass; you might seem to be moving, but you could be going in the wrong direction entirely.
This psychological blind spot can lead to poor financial decisions by creating a distorted picture of performance and wealth. It’s a common and costly mistake.
The most classic example is the salary raise. Imagine you get a 3% raise at work. You feel great! But if the inflation rate for that year is 5%, your “raise” is actually a 2% cut in your purchasing power. You have more euros or dollars, but you can buy less with them. The nominal increase in your salary creates the illusion of progress, while the real value of your income has decreased. A true value-oriented mindset looks past the nominal number to see if their economic reality has actually improved.
Money illusion runs rampant in the world of stocks and bonds. An investor might be thrilled with a 5% annual return from a bond or a high-yield dividend stock. On the surface, it looks like a solid gain. However, if inflation is running at 4%, the real return on that investment is a meager 1% (5% nominal return - 4% inflation). You've barely outpaced the decay in your money's value. The goal of a value investing strategy is not just to accumulate more currency, but to increase your command over real goods and services. Always subtracting inflation from your returns is the first step toward financial clarity.
Homeowners often fall victim to money illusion. Someone might boast, “I bought my house for €200,000 twenty years ago, and now it's worth €400,000!” While the nominal price has doubled, this statement ignores two decades of cumulative inflation. When adjusted for inflation, the real increase in value is often far less impressive. Furthermore, this simple calculation ignores ownership costs like property taxes, insurance, maintenance, and transaction fees. A savvy investor calculates their return only after accounting for all costs and the impact of inflation.
As an investor, your primary defense against money illusion is to build a habit of thinking exclusively in real, inflation-adjusted terms. This is a cornerstone of the philosophy championed by figures like Warren Buffett.
Make it a mental rule to translate every financial figure into its real value. The key is to understand and use the concept of the real interest rate. While the precise formula is more complex, a very useful approximation is: Real Return ≈ Nominal Return - Inflation Rate By consistently applying this simple formula to your salary, investment returns, and savings, you immunize yourself against the false comfort of nominal gains. You start seeing your wealth as it truly is: a measure of your purchasing power.
One of the best long-term hedges against inflation is owning businesses that can pass rising costs onto their customers without losing business. This is known as pricing power. Companies with strong brands, unique products, or dominant market positions can raise their prices to match or exceed inflation, thereby protecting the real value of their earnings. As a value investor, analyzing a company's ability to maintain its profitability in an inflationary environment is a critical part of the due diligence process.
For parts of your portfolio focused on capital preservation, it can be wise to own assets explicitly designed to combat inflation. Government-issued bonds like Treasury Inflation-Protected Securities (TIPS) in the U.S. adjust their principal value based on the official inflation rate, ensuring your investment keeps pace. While not a tool for high growth, they serve as a reliable shield against the erosion of purchasing power.
Money illusion is a powerful and pervasive bias because it plays on our desire to see progress. It’s easy to celebrate rising numbers and hard to accept the invisible drain of inflation. But the most successful investors are realists. They pierce the veil of money illusion by rigorously focusing on what matters: the sustainable growth of their real, after-inflation purchasing power. Don't be fooled by more dollars; demand more value.