Unveiling the power of money illusion (2024)

Money, the universal medium of exchange, has an undeniable influence on our lives. From the moment we earn our first bit of pocket money, to our first salary, all the way to when we retire, financial decisions are part of our lives. However, our perception of money isn’t always as rational as we’d like to believe it is.

This post discusses a very sneaky cognitive bias known as money illusion. We share several money illusion examples so you’ll be very familiar with it by the end of this. And of course, we’ll end with some practical tips of how you can better equip yourself to not be fooled by this one.

1. A basic financial knowledge question
2. What is money illusion?
3. When we forget about inflation and compounding
4. Money illusion and framing
5. Rice and a chessboard
6. Exponential growth bias and pyramid schemes
7. The impact of money illusion on financial decision making
8. Practical ways to manage money illusion

In financial literacy research, there are 4 standard financial knowledge questions developed by Anamaria Lusardi and Olivia Mitchell, that groups of subjects are always asked in any study. Let me share one with you:

Suppose that in the year 2030, your income has doubled and prices of all goods have doubled too. In 2030, how much will you be able to buy with your income?
• More than today
• The same as today
• Less than today
• Do not know

It’s testing a basic financial knowledge concept known as exponential growth bias. Or as we like to call it: Money illusion.

Money illusion refers to our tendency to misinterpret changes in the nominal value of money without considering inflation. We focus on the amount of money in our hands, rather than it’s purchasing power.

In essence, money illusion is… illusory. This is why many think you can never go wrong with property.

Think about how much businesses paid for instant worldwide communication back in the day, compared to how cheap internet access is today. Money illusion causes us to focus on the amount of money rather than it’s worth.

Money illusion causes us to think about money in nominal terms rather than real ones. Click To Tweet

John Maynard Keynes was the first to document that the average person views their wealth and income in nominal terms rather than real terms. Irving Fisher then further expanded upon this idea.

Imagine receiving a nominal wage increase of 5%. It sounds like a decent increase, but if inflation is at 6%, your purchasing power is actually decreasing. This is a classic example of money illusion – you’re being influenced by the nominal increase and nominal incomeand overlooking the real value of your real wages.

This explains why people put significant portions of their cash in low interest savings accounts, and why others get really excited about large multiple of value increases in housing prices without thinking through what it actually equates to in real terms.

Ultimately, higher periods of inflation are great for long term investors, as assets are discounted due to money illusion. Add the phillips curve and price stickiness to this and everything is impacted by money illusion – revenue, profits, asset prices, valuation ratios. This is one of the reasons why it’s difficult to compare the value of assets between decades – a price-earnings ratio in a decade of high or increasing inflation will be less real than one when inflation was low.

Price is what you pay. Value is what you get. Click To Tweet

Here’s another question for you. If I had to give you the choice between the following two options:

1. Over the next 30 days, you receive $1,000 every day.
2. Over the next 30 days, you receive 1 cent on the first day, 2 cents on the second day, 4 cents on the third day, 8 cents on the fourth day, and so on.

Which would you choose?

Option 2 is the better choice. Where option 1 gives you a total of $30000 in 30 days, option 2 give you more than $5 million!

Our inability to see the growth potential with option 2 is because we’re accustomed to seeing things linearly, not exponentially. Once you start understanding exponential growth though, it’ll be clear why Albert Einstein said that “Compound interest is the 8th wonder of the world…”

Because we don’t think exponentially, information is often framed in such a way to either under – or – overplay our response to it. As an example, you could receive information as follows:

“The number of people who die in motor accidents increases by 14% every year.”

You’ll likely recognise that deaths on the road are increasing, but it’s unlikely you’ll comprehend the scale of that increase.

Alternatively, you could receive the same information, framed slightly differently, as follows:

“The number of people who die in motor accidents doubles ever 5 years.”

Now that shows the scale. (For those that want to check my maths – go ahead – the stats are identical.)

Similarly, if the growth in the rat population in your neighbourhood is going up at 10% every year, a journalist that wants to garner a response from the community will likely rather headline with “Rat population will double in 7 years!”

Consider an ancient Persian legend about some rice and a chessboard:

There was once a wise sage, who presented a King with a chessboard. The King was so impressed by the gift that he offered the sage any gift of his choosing. The sage responded ‘I want nothing more than to be paid in grains of rice’ and requested the king to put one grain of rice on the first square of the chessboard and then doubling it on every subsequent square. The king promptly agreed and asked for a bag of rice to be brought to the chessboard. Only when his servants began the task – placing a grain on the first square, two grains of rice on the second square, four grains of rice on the third, and so on – did her realise that he would need more rice than what was growing on earth!

To help our linear brains accurately grasp the scale of this exponential growth, I’ve done some calculations to show how much the sage would actually receive.

There are 64 squares on a chessboard. On the first row of the chessboard, which has 8 squares, the sage receives:

It’s not that promising to begin with. The growth is slow. But let’s persevere.

On the last square (#16) of the 2nd row, the sage would receive 32 768 grains of rice!

And this what the 3rd row would look like:

Quite a different story now.

On square 32 (we’re exactly half-way), the sage receives 34 359 738 368 grains of rice reaching a cumulative total of 68 719 476 735 grains.

Let me really blow your mind and start putting this in monetary terms. 1kg of rice equates to approximately 15 432 grains of rice. So, on square 32, the sage has 4 453 050 kg’s of rice. How much does rice cost? Well, I suppose the legend isn’t clear about the type of rice, so let’s just take an average price of R40 (or $2) per kg.

You ready?

That equates to R178 122 024 (or $9 433 974)!!

And we’re only halfway along the chessboard!

I know you’re curious about the final square (#64). The final square gets 18 446 744 073 709 551 615 grains of rice. The cumulative total now = too many numbers for me to type!

The results of this breakdown help us see that the growth is slow to begin with, but once it gets going, it really gets going. Similar to our investments. We might feel that we don’t have much to save, so we save nothing. But what we’re failing to see is that compounding works on even the smallest amounts.

Simplistically, you pay $1000 to invest in the business (substitute this ‘investment’ with anything you like, beauty products, forex, weight-loss formulas, anything). The principle is the same, all you need to do is recruit 4 new people who will each pay you $1000. Those 4 new recruits then recruit 4 more people, and on it goes.

It’s a very attractive business venture because it looks like you’re guaranteed a large profit. But, these schemes are illegal for good reason – they don’t work. Given the exponential growth required you’ll soon be unable to recruit enough people at the next level, which will leave everyone at the previous level with no money coming in.

Don’t fall for scams!

Money illusion impacts our savings and investment choices. Because we perceive money to have more value than it does (due to inflation), we underestimate the amount we need for retirement and other long-term goals. So, we don’t save or invest enough to secure our financial future.

Similarly, money illusion impacts our debt management decisions. When interest rates are low, we may be enticed to take on more debt, as the nominal interest rates seem attractive (recall our conversation with Wynand about being anchored to interest rates). If inflation is high, the real cost of servicing that debt might be significantly higher than we might have anticipated.

Once you’ve familiarised yourself with the power of exponential growth, you’ll hopefully understand why many people create such a noise about having an awareness of the fees you pay on your investments. They’re usually disclosed in percentages, and the numbers are tiny. Perhaps your financial advisor charges a fee of only 2.5%. That doesn’t sound like a lot at all. When you start investing and you have $1000, that’s only $25. But consider how that $1000 is going to grow? Especially if you continue making contributions. It happens slowly, so you hardly see it, but eventually, that 2.5% is a large fee in your financial plan!

We must also apply this same thinking to inflation. If inflation is at 7%, that means the value of your $1 will be half that in 10 years. This can be quite a shattering realisation for anyone whose investments are not earning above inflationary returns.

When it comes to growth rates, don’t go with your intuition. Use a calculator.

When you get that option to pay the full years school fees upfront at a ‘discounted rate’ rather than monthly, do the maths. Use a calculator.

When you don’t want to put through a claim with Outsurance because you don’t want to lose your Outbonus, do the maths. Use a calculator.

To end, here are some useful strategies to help you navigate financial decisions with a clearer perspective:

Focus on real value: Always consider the purchasing power of your money rather than just the numbers. Factor in inflation when evaluating financial decisions and financial planning.

Financial education: Educate yourself about economic principles, especially those related to inflation, compound interest, and investment. Understanding these concepts will help you make informed decisions. For bonus points, understand how modified demand conditions arise and how prices respond differently in different market conditions. This will help you identify when you’re sitting with decreasing real wages.

Use real rates: When analysing investments or loans, use real interest rates (adjusted for inflation) to assess their true value. This is essential for wealth management.

Diversify investments: Diversification can help mitigate the impact of money illusion. A well-diversified portfolio can protect your wealth during periods of inflation.

Regularly review finances: Keep track of your financial situation and adjust your strategies as economic conditions and resources change. Regular reviews can help you adapt to inflationary periods.

Money illusion is a cognitive bias that can significantly impact our financial decision-making. By recognizing its presence in our lives and applying strategies to overcome it, we can make informed and prudent choices that align with our long-term financial goals. Remember, it’s not just about the numbers related to your money; it’s about the real value it holds in your life.

• Heuristics and biases in decision making – This was the first post in the series which shares some behavioural economics research. Specifically, the heurstics and biases that influence our relationship with money. It uses System 1 and System 2 thinking examples from Daniel Kahneman’s New York Times best selling book, Thinking Fast and Slow, to help us be more conscious of the workings of our brain.

• Mirror, mirror, on the wall, stop telling me I’m wonderful – This post focuses on the impact of overconfidence bias in decision making. It introduces the illusion of knowledge bias and the illusion of control bias to illustrate the difference between confidence and carelessness. It also discusses the better than average effect, the self-serving bias and fundamental attribution error. You’ll learn how to confront some unpalatable truths and get out of any false sense of comfort (if you’re up for the challenge?).

• Why you can’t argue with a vegan – Ballsy title, we know. But if you read the post you’ll (hopefully) understand why. We’ll be discussingconfirmation bias. It’s one of those psychological biases that you can see everywhere. We’ll also touch on cognitive dissonance theory. We all struggle with these biases. They’re both humorous and serious. But because of that, it’s useful to know how to avoid confirmation bias when you need to.

• Size does matter… when it comes to framing – This post uses framing effect examples to show how framing bias influences the way we interpret information and make decisions. We discuss glossing, the compromise effect, and how the size of the frame can influence the volatility of your investment portfolio.

• Loss aversion vs risk aversion – Once you understand framing, you’re ready for this post. It introduces an incredibly powerful bias known as loss aversion. It also touches on prospect theory, the disposition effect and impression management.

• Anchors pulling you down? – Anchoring bias is a straightforward behavioural bias that causes us to focus on a certain initial value and then make decisions with reference to it. This posts looks at some examples of this anchoring effect.

• The danger of the default – Default options nudge us to make better decisions. The option of opting out also respects freedom of choice. This post unpacks this notion of libertarian paternalism and the perils of status quo bias.

• Regret, it’s not a nice feeling– Regret influences the decisions we make andpushes us to conformto social norms.Examples of regret avoidanceshow us how this makes complete sense yet no sense at all.

• When the past influences the future – The Concorde effect is a famous example of sunk cost investment. Too often we invest time, money and energy into something we should’ve just abandoned. This post looks at some examples of how sunk cost fallacy affects our human decision processes.

• What’s mine is more valuable – In this post, you’ll learn why you place extra value on things you own. The endowment effect has implications for our investment portfolio, bonuses and consumer behaviour.

• How to improve self-control – Self-control is an essential life skill. It’s what separates humans from the rest of the animal kingdom. Learn how to improve self-control to achieve your long-term goals.

• Procrastination is the enemy of success – We know procrastination is the enemy of success. But while it looks like laziness, it’s often just mental exhaustion at play. Learn how to overcome procrastination.

• The problem with wanting it now – When you delay instant gratification, you will experience long-term satisfaction. It’s the hyperbolic vs exponential discounting debate. Don’t let present bias win!

• The power of first impressions – The order of information influences your decisions. First impressions matter! It’s all got to do with primacy and recency effects.

• We prefer wrong information to no information – Availability bias and survivorship bias influence our decision-making. We make decisions based on the information available to us.

• Learn to deal with uncertainty – Risk and uncertainty will always surround us. Gambler’s Fallacy, the hot-hand effect, the law of small numbers & ambiguity aversion are just some of the biases that arise because of it.

• Stop stereotyping – Representativeness heuristic refers to the fact that we stereotype. It’s a mental shortcut. But beware of making unfounded comparisons.

• Mental accounting – Money is money! Or is it? Mental accounting says we place different values on different money which leads to irrational decision making.

• Home bias – We invest close to home and in what we know. But this lack of diversification results in missed opportunities. Say hello to ‘home bias’.

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