Money illusion refers to the tendency of individual investors to think of investment returns only in terms of nominal value. The term was coined by the economist John Maynard Keynes in his early twentieth century writings.
Nominal value only uses current market value without taking into account the past and future effects that inflation has on the purchasing power of an investment. The alternative is to use real value, which is the value after accounting for the effects of inflation.
Imagine you purchase a bond for $100 that pays an annual 5% rate of interest. You begin the year with $100 and will finish the year with $105. However, the $5, or 5%, you received is the nominal interest rate and does not account for the effects of inflation. Whenever interest rates are quoted, they refer to the nominal rate of interest, unless it is stated otherwise.
If the inflation rate was 3% for that year, then a $100 item that you could purchase at the beginning of the year would cost $103 by the end of the year. If you take into account the effects of inflation, then the $100 bond has earned a real return of only 2%.
Money illusion can influence your perception of which outcome is most beneficial to select. You will tend to choose a 4% nominal investment return in an environment of 2% inflation, over a 2% real investment return, even though the real returns of the two alternatives are equivalent. You believe that the 4% quoted interest rate has to be more attractive because it appears to be greater.
A dollar today is worth more than a dollar tomorrow and they are both worth much more than the value of a dollar in forty years. Inflation erodes the future purchasing power of your investments. This erosion is deceiving to most individual investors because it occurs slowly and compounds over time.
A proxy for the rate of inflation in Canada is shown by the monthly price change in the consumer price index (CPI). This index calculates changes in the cost of a fixed basket of consumer items that includes food, shelter, furniture, clothing, transportation and recreation.
In the forty year period from 1970 to 2010 the average annual inflation rate was 4.45%. A $100 investment in 1970 had to increase to $570 by 2010 just to maintain the same real value.1.
You need to overcome the effects of money illusion in order to understand how inflation affects the real purchasing power of your investments over long time horizons.
1. Bank of Canada http://www.bankofcanada.ca/en/rates/inflation_calc.html