Business

Beware of the illusion of money as inflation rises. It may cost you a lot.

As inflation rises in the United States, blind spots known as the illusion of money can cause many to make serious financial mistakes.

Simply put, the illusion of money is that people usually tend to think of the nominal dollar (the amount actually spent or earned) rather than the actual dollar, which is the purchasing power of money after considering inflation. Refers to the facts.

This is a simple formula called the “Rule of 72”. This makes it easy to understand the powerful effects of inflation over time and how much the illusion of money can hurt. Take 72 and divide it by the annual inflation rate. The resulting numbers show how many years it will take to cut purchasing power in half.For example, based on the August core Inflation rate of 3.6%In 20 years (72 divided by 3.6), your current income will buy you only half of today. This means that if you go out for dinner with someone, you can only buy it once every 20 years for the same amount as buying two meals today.

To see if you are at risk of the illusion of money, consider the following questions. Frequently cited treatises By Eldar Shafir, Peter Diamond and Amos Tversky. The question looks like this:

Adam, Ben, and Karl each received $ 200,000 in inheritance and bought the house for the same amount... Each of them sold the house a year after they bought it.Economic conditions were different in each case..

  1. There was 25% deflation when Adam owned the house. A year after Adam bought the house, he sold it for $ 154,000. This is 23% less than the amount he paid...
  2. When Ben owned the house, the price remained the same. Ben sold the house for $ 198,000. This is 1% less than the amount he paid.
  3. There was 25% inflation when Karl owned the house. A year after buying the house, Karl sold it for $ 246,000. This is 23% more than he paid.

Who made the best deal? Who made the worst deal?

According to research, the most common answer is that Karl made the best deal and Adam made the worst deal. After all, Karl got the best selling price in nominal dollars.

However, in real dollars, these answers are the opposite. Karl had the worst results — he lost 2% of his money in inflation — and Adam did his best with a 2% profit. In fact, only Adam made a profit in real dollars.

Share your thoughts

How has inflation affected your savings and spending this year? Join the conversation below.

If, like most people, Karl thinks he has made the best deal, make a long-term economic decision now, as rising inflation can affect every stage of your economic life. You need to be especially careful when. Here are some areas where it costs money to pause and see if you are making a decision through a distorted lens of the illusion of money.

Home ownership: Let’s say you are about to buy a house. If you’re worried about inflation, fixed-rate mortgages may be your best choice. Home prices tend to rise with inflation, but mortgage payments are fixed, so the higher the inflation, the faster you build equity.

insurance: Check the coverage of home insurance. Suppose you bought a home in New York in 2000 and forgot to adjust your home insurance coverage. If a home is damaged by a recent storm, only 63% of the current home can be replaced, given inflation and rising construction costs. The same principles apply to long-term care and life insurance. Inflation means that you are likely to provide much less support today than you initially expected.

investment: Take a look at your portfolio. Some baby boomers seeking a stable retirement income may hold most of their portfolio in fixed income, considering it to be a low-risk investment. Unfortunately, inflation can devalue even the safest bonds, such as 10-year and 30-year government bonds. For example, if long-term inflation expectations rise by just 1%, the price of 30-year government bonds could fall by 20%. Also, if you don’t plan to sell your bond and don’t mind price fluctuations, future coupon payments will also lose the value of inflation. This is the power of inflation. You can turn a seemingly safe investment into a risky asset.

Savings for retirement: Let’s say you are a 30-year-old worker who plans to retire at the age of 70. Looking at your expected retirement income, you feel that an annual income of $ 50,000 is sufficient. But if that number isn’t adjusted for inflation and many retirement calculators aren’t adjusted, then an annual 3.6% inflation rate (August inflation) would be $ 50,000, equivalent to $ 12,150 at retirement. It means that you can only buy for consumption. ..

Post-retirement spending: Are you considering buying a financial product designed to help retirees cover future costs? Many are not protected from inflation. For example, longevity insurance offers payments in exchange for lump sum payments after a retiree reaches a certain age. However, longevity insurance usually does not take inflation into account, which can reduce the purchasing power of retirees, especially if they purchase insurance products much earlier. If you buy at 65, start at 85, and inflation remains at 3.6%, you can only buy half of the commodity for every dollar in the future.

More generally, consumers of all ages need to look at the impact of inflation on their households as prices rise at different rates in different categories. If you don’t explain inflation in your financial plan, you’ll almost certainly feel the impact over time. The important thing is to take action before you feel the pain of rising prices. If you notice the pain, it’s probably too late.

Dr. Benalzi (@shlomobenartzi) Is a professor at the UCLA Anderson School of Management, co-head of a behavioral decision-making group, and a frequent contributor to Journal Reports.Please email him reports@wsj.com..

Inflation in the United States has reached its highest level in 13 years, causing debate over whether it is entering a period of inflation similar to that of the 1970s. WSJ’s Jon Hilsenrath is looking at what consumers can expect next.

Copyright © 2021 DowJones & Company, Inc. all rights reserved. 87990cbe856818d5eddac44c7b1cdeb8



Beware of the illusion of money as inflation rises. It may cost you a lot.

Source link Beware of the illusion of money as inflation rises. It may cost you a lot.

Back to top button