As Inflation Rises, Beware of the Money Illusion. It May Cost You a Lot.

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People often focus on the actual amount they earn or spend rather than its purchasing power.

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Here’s a simple formula, called the “rule of 72,” that makes it easy to understand the powerful effects of inflation over time — and how much damage the money illusion can do. Take 72, and divide it by the annual inflation rate. The resulting number tells you how many years it will take for your purchasing power to halve. For example, based on the root of August Inflation rate 3.6 percent, in 20 years (72 divided by 3.6), your current income will only buy you half what it is today. This means that if you go out to dinner with someone, the same amount of money that buys you two meals today will only buy you one in 20 years.

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To see if you are at risk from the money illusion, consider the following question, which is called a . adapted from highly cited paper By Elder Shafir, Peter Diamond and Amos Tversky. The question is as follows:

Adam, Ben and Carl inherited $200,000 each and bought a house for the same amount. Each of them sold the house a year after they bought it. The economic situation was different in each case.

  1. When Adam had the house, there was 25% deflation. A year after Adam bought the house, he sold it for $154,000, 23% less than what he paid.
  2. When Ben owned the house, the prices remained the same. Ben sold the house for $198,000, or 1% less than he paid for it.
  3. When Carl owned the house, there was 25% inflation. A year after buying the house, Carl sold it for $246,000, or 23% more than he paid for.
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Who got the best deal? Who got the worst deal?

According to research, the most popular answer is that Carl got the best deal and Adam got the worst. Carl, after all, received the highest selling price in nominal dollars.

However, in real dollars, these answers are backward. Carl did the worst—he lost 2% of his money to inflation—and Adam did his best, with a profit of 2%. In fact, it was only Adam who made a profit in real dollars.

If, like most people, you think Carl’s got the best deal, you should be especially careful when making long-term financial decisions right now, as rising inflation can affect every stage of your financial life. Here are some areas where it pays to stop and see if you’re making decisions through the distorted lens of the money illusion.

home ownership: Let’s say you are looking to buy a house. If you are concerned about inflation, a fixed rate mortgage may be the best option. Housing prices rise with inflation, but your mortgage payments are fixed, so higher inflation means you’re building equity faster.

Insurance: Review your home-insurance coverage. Let’s say you bought a home in New York in 2000 and forgot to adjust your home-insurance coverage. If your home was damaged by a recent hurricane, you will only be able to replace 63% of your current home, given inflation and increased construction costs. The same principle applies to long-term care and life insurance. Inflation means it will provide far less support than you initially imagined today.

Investment: Take a look at your portfolio. Some baby boomers who want a steady income in retirement may have a large portion of their portfolio in bonds, thinking these are low-risk investments. Unfortunately, inflation can cause even the safest bonds, such as 10- and 30-year Treasury bonds, to decline in value. For example, if long-term inflation expectations rise by just 1%, the price of a 30-year Treasury bond could drop by 20%. And if you don’t plan to sell your bonds, and thus ignore price fluctuations, future coupon payments will also lose value to inflation. This is the power of inflation – it can turn a safe investment into a risky one.

Saving for Retirement: Let’s say you are a 30-year-old employee who plans to retire at age 70. You look at your projected retirement income and realize that $50,000 a year in income will suffice. But if that number isn’t adjusted for inflation — and many retirement calculators aren’t — an inflation rate of 3.6% annually (the inflation rate in August) means that $50,000 will only buy you $12,150 worth of consumption at retirement. .

Retirement expenses: Are you considering purchasing a financial product designed to help retirees deal with future expenses? Many are not protected from inflation. Longevity insurance, for example, provides payouts to retirees after they complete a certain age in exchange for a lump sum. However, because longevity insurance typically does not take inflation into account, it can leave retirees with less purchasing power, especially if they purchase insurance products much earlier. If you buy at 65, and it starts at 85, and inflation stays at 3.6%, each future dollar will only buy you half the goods.

In general, consumers of all ages should watch the effects of inflation on their household budgets, as prices rise at different rates in different categories. If you fail to account for inflation in your financial plans, you will surely feel its impact over time. It is important to take action before you feel the pain of rising prices, because once you notice the pain it is probably too late.

Doctor. benertzii (@shlomobenartzi), is a professor and co-head of the Behavioral Decision Making Group at the UCLA Anderson School of Management and a frequent contributor to Journal Reports. Email him at [email protected]

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