Money illusion and your financial decisions

In today’s post we will see how human mental calculations affect their thinking perception about finance. This perception is called “Money illusion”. Money illusion in economic terms defined as tendency of the human to think currency in nominal value rather than real value.

Nominal value means value which is not adjusted to inflation and real value means, value which is adjusted to inflation. For example, suppose you earned around 12% return from any investment and the inflation rate for that period is around 7% then 12% is called nominal return or nominal value and 5% (12%-7%=5%) is called real return or real value.

All may claim that they understand this point, but when actually we look with some examples, we may easily find out that even we too have that tendency of money illusion 🙂 So let us look at few examples in detail.

1) Consider two individuals Mr.X and Mr.Y who just graduated from college and took the job immediately. Suppose Mr.X got the salary package of Rs.5,00,000 PA and during that period consider neither inflation nor deflation (means inflation is zero) and in second year he got around 2% raise. Mr.Y got the salary package of Rs.5,00,000 PA and during that period consider inflation rate as 4% and he got around 5% raise in salary in his second year.

Then according to you in terms of finance who is doing better? Majority of answers to this will be obviously Mr.X. Suppose questions are asked in second year like-who will be more happier? then answers will be Mr.Y because he got the salary hike of 5%. Also when questions are raised about who will be more interested in changing the job then most probably answers are Mr.X.

This shows that when people think purely on economic or financial terms then they usually consider real value. But when it comes to happiness, feelings, well being and social status issue, people tend to consider nominal value rather than real value. Few of your views may be change to what I say above. But these are the common decisions. You will get more clarity with below few examples.

2) Suppose you have the business of computer selling and today’s price of each unit is Rs.45,000. You have been asked to do agreement now to sell computers to XYZ company  and the delivery will be after two years from now (October 2014). Experts feel that inflation will raise to 20% during this two year period. Considering this, you have these four choices. Read carefully.

a) You have first choice of selling at 20% higher than the current price in 2014. You  will get benefited if your predictions are correct. If it raise to more than this then you will loose similarly less means you will get benefited  So your entire profit is depend on the raise or fall of the inflation.

b) You have second choice, where you just need to sell at the prevailing price of October 2014. If inflation is more than 20% then you will get more and less then get less. So in this transaction no risk at all.

Now read carefully the below two more choices.

c) You have choice to sell the computers at 20% more than the current price in the year of October 2014.

d) You have choice to sell the computers at the whatever rate on October 2014.

When people read first two conditions then obviously they select the the option “b” as it is riskless transaction for them. But when I removed the word inflation from options c and d then it is human tendency to select the option “c”. Am I right??

3) Suppose Mr.X, Mr.Y and Mr.Z have purchased new 3 houses on the same day by each investing Rs.50,00,000 and all the three sold their houses after one year. Let us consider inflation for Mr.X -25% (25% deflation), Mr.Y 0% (zero) inflation and for Mr.Z 25% inflation. Selling price for Mr.X is Rs.38,50,000 (23% lesser than for what he purchased), for Mr.Y selling price is Rs.49,50,000 (1% less than for what he purchased), and Mr.Z selling price is Rs. 61,50,000 (23% more than his purchased price).

Now their nominal returns for Mr.X, Mr.Y and Mr.Z are -23%, 1% and 23% respectively. But the real returns are (inflation adjusted) 2%, -1% and -2% respectively. But when you ask someone to rank their transactions then majority will rank Mr.Z in first place, Mr.Y in second place and Mr.X in third place. Because they saw the nominal value of transactions instead real value.

4) One more strong example how people tend to always calculate nominal value rather than real value is salary hike. People get irritated when they saw any salary cut or low hike  but enjoy good hike. But they never compare the real value in terms of inflation. Suppose you got salary hike of 1% when inflation is around 6% is equal to salary hike 10% when inflation is 15%.

Hope above few examples made you understand the illusion we have about money. This illusion is the effect of not considering inflation into our day to day transactions and financial life. One more reason for this illusion is, very low penetration of the term called “Financial literacy” . Because for normal person it is easy to calculate nominal values rather than real values. Hence need of the hour is financial literacy.