When making decisions about your wealth, it’s important to be aware of cognitive biases – systematic patterns of thinking based on past experiences or a misrepresentation of information.
There are many different cognitive biases that could affect you without you realising, and this could lead to poor decision-making.
The “money illusion” is one such bias that may make it challenging for you to build a clear picture of your current financial position and work towards your long-term goals.
The money illusion causes you to see your wealth in nominal rather than real terms
If you want to know how much you have in your savings, you can check your bank balance. But it’s important to consider what that figure actually means, and what the real-terms value of your wealth is.
This could be more difficult if you fall victim to the money illusion because you tend to view money at face value, rather than in relation to its real-world value.
For example, you might believe that £100,000 is a significant amount of money. And, of course, it is.
Yet, it’s important to consider the relative value of your wealth. You wouldn’t feel that £100,000 was a notable amount if a loaf of bread cost £200,000. In other words, the true value of your wealth is tied to the goods and services you can purchase with it.
If you fall victim to the money illusion, you may fail to recognise this and only view your finances in terms of the numerical value.
This could affect the way that you approach your financial plan and the decisions you make in several ways.
You could underestimate the effects of inflation if you fall victim to the money illusion
As you progress in your career and your earnings rise, you might be able to improve your lifestyle in the short term and contribute more to your savings.
However, the money illusion could mean that you underestimate the effects of inflation, and your earning potential is not as high as you believe.
This happens if you only focus on the amount you earn without considering how much you can buy with your salary.
If you earned £100,000, for example, and received a pay increase of 2%, you would now earn £102,000. On paper, you are £2,000 better off.
Although, if inflation was 5%, the same goods and services that cost £100,000 a year ago would now cost £105,000. So, in reality, you are £3,000 worse off, even though the nominal value of your salary has increased.
Over time, this could mean that the real-terms value of your earnings is actually falling, making it more difficult to maintain your current standard of living. You may also have less disposable income and may contribute less to your savings.
The money illusion could affect you in a similar way when it comes to your savings. If you’re earning 2% interest a year on your cash savings, you might feel that you’re generating enough growth to achieve your desired standard of living when you’re older.
But if inflation exceeds 2%, as it has in many previous years, your savings might actually be losing value.
That’s why it’s important to consider the spending power of your savings, rather than the nominal value. You may also want to explore options for investing, which may be more likely to help you achieve inflation-beating growth.
We can support you with this.
The money illusion could affect your spending decisions
Budgeting is a crucial aspect of financial planning because it allows you to control your spending and ensure you have enough disposable income to save for the future. The money illusion could make this more difficult to achieve because it often distorts your decisions about spending.
If you underestimate the effects of inflation and believe that the value of your salary has risen significantly, you might increase your spending accordingly. Unfortunately, if the real-terms value of your salary is much lower than you realise, this adjustment to your lifestyle might not be sustainable.
It’s also important to consider how you view the value of your wealth when deciding if a purchase is worthwhile or not.
For example, you might spend £100 a month on a cleaner. This could be worthwhile as it might free up more time for you to spend with your family.
Conversely, spending £100 a month on a gym membership that you don’t use likely won’t improve your life in any meaningful way.
If you are driven by the money illusion and only consider the nominal value of the £100, you might view these two expenses as being equal. Yet, one cost is adding value to your life while the other isn’t.
This is a simple example but it demonstrates the importance of understanding your values and what will have a meaningful effect on your life – rather than only considering the numbers – when deciding how to use your wealth.
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We can help you avoid the money illusion and understand the true value of your wealth.
Please get in touch or email us at advice@mlifa.co.uk for more information.
Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
All information is correct at the time of writing and is subject to change in the future.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.