Inflation and the resulting Money Illusion
€1 today isn’t worth the same as €1 was ten years ago.
Or even one year ago.
In nominal terms yes but in real terms, i.e. what it can purchase, it’s not.
What causes this?
Inflation.
Undoubtedly one of the buzzwords of 2022.
Whether or not you are conscious of inflation, it plays a major role in financial planning and indeed your life.
You can choose to acknowledge it and deal with it or not.
However, ignore it at your peril.
The money illusion refers to a cognitive bias that fails to take inflation into account.
What is the ‘Money Illusion’?
The money illusion is the tendency to think of your money in nominal value versus real terms.
It is sometimes known as the ‘price illusion’.
When you think in nominal terms, external factors such as inflation are not considered.
The nominal value is not the same as the real value.
For example, the real value of two shirts might be the exact same because they cost the same to manufacture, but one might sell at a higher price point due to demand, marketing, reputation, and brand name.
These external factors here contribute to the real cost of the shirt.
The same applies to your money.
If you get a 5% interest rate (if only!), but inflation is 7%, you’ve lost 2% of real value.
More realistically, if you have €100,000 in the bank earning zero interest but inflation is 8%, the real value of that is only €92,00.
Yet, you still have €100,000 in the bank creating the illusion that €100,000 is worth €100,000 in real terms.
There is one main reason why the money illusion continues to play a role in the way we think about financial planning.
It comes down to a simple lack of financial education.
If it’s not in the news, many people don’t know the rate of inflation or don’t understand how it impacts the real value of their income.
Then again, maybe they do but they choose to ignore it. At their peril.
Example
Coming back to the bank example as it is nice and simple.
You have €10,000 in the bank today.
Next year, one year from now you still have €10,000 in the bank.
But only in terms of the number of zeros attaching.
In real terms, you have less as inflation has reduced the real value of that €10,000.
Something that costs €50 will cost more than €50 one year from now.
That’s inflation.
Yet, your €10,000 remains the same number due to low-interest rates.
Everything around you is rising in cost yet your money is staying the same.
What is inflation?
In its simplest form, inflation means the cost of goods rise.
The higher the rate of inflation, the quicker prices are rising.
This rise, reflected as a %, means your Euros buy less than they did previously (purchasing power).
Look at your energy bills increasing.
That’s inflation at work.
Yet, your hard earned Euros remain in the bank, credit union, and post office earning little or no return to keep pace.
Inflation is a stealth tax on your money.
Grab your free downloadable guide to inflation by clicking here.
Traditional saving options
Traditionally, people use the bank. credit union or the post office.
These are what I class as the old favourites, they feel secure.
Banks and credit unions, depending on the account type, are offering little or no return.
An Post is there and they are the best of a bad bunch.
They offer 1% return over 3 years.
Go longer, 4 years it goes up to 2%, for 5 years 3%.
Fact: These returns are still poor.
Furthermore, what alot of people don’t know, they are also mostly back-ended, ie the return accumulates at the end of the term.
However, let’s say inflation is 2% per annum, that return on offer still doesn’t cut it.
Inflation just eats away at the value of your money.
Without a doubt, whether you have a lump sum sitting in one of these institutions or save regularly into them, the effect is the same.
How The Money Illusion May Impact Financial Planning
As can now see, the money illusion is a tricky cognitive bias.
it affects your finances and can put you behind your goals.
In today’s terms, if you thought you needed €1 million to retire comfortably in 10, 20, or 30 years when you are actually ready to retire, what does that equate to?
How to deal with The Money Illusion
You can choose to ignore inflation.
The real purchasing power of your income will diminish.
The alternative, build a solid financial plan and strategy that factors in inflation.
Understand and learn how much money you will need to pursue your long-term goals.
You can work with us to create a financial and investment plan that hedges against inflation.
How we help you
The average rate of return of the S&P 500 index is about 8.9% per year*
However, within the different years, there will be some significantly high years and some significantly low years.
This means that if you invest to some degree, your investments will help you minimize the impact of inflation over the long term.
You do not need to invest in the S&P 500 if you can’t stomach the rollercoaster it creates.
We will work with you to create a plan specific to you and your family.
Not just an investment plan, both a financial plan and then an investment plan to support your financial plan.
This helps you combat the effects of long term inflation.
Firstly, part of your plan will be liquidity, keeping cash you can access at short notice.
We don’t recommend you invest every last Euro, everyone needs funds available to access.
We will ensure you have cash available, particularly in case of emergencies.
Secondly, we will then take the time to clearly explain how investments work, get you comfortable and outline the strategy behind our recommendations.
We don’t invest you in a single stock or share where you can lose everything.
Our investment philosophy doesn’t believe in that level of risk..
If you want to invest in the next best thing, we are not the firm for you.
We create diversified portfolios, specifically for your own individual objectives.
Get in touch
To discuss further email us at info@fortitudefp.ie or request a callback.
Alternatively, you can get us on 086 0080 756 or access our diary here and book a call at your convenience.
Why not visit our insights.
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Our blog posts are intended for information purposes only and should not be interpreted as financial advice.
You should always engage the services of a fully qualified financial planner before entering any financial contract.
To discuss engaging the services of Fortitude Financial Planning please email us at info@fortitudefp.ie.
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