Categories: Behavioral Finance
      Date: Nov 17, 2011
     Title: Thinking Clearly About Inflation

In planning for your financial future, accounting correctly for inflation is absolutely critical. Unfortunately, thinking clearly about the impact of inflation isn't something most people do naturally. Most of us have a tendency toward what behavioral economists call "money illusion", where we think about dollars in "nominal" terms, as opposed to their "real" or inflation-adjusted value. We routinely confuse the face (nominal) value of money for its purchasing (real) value.

Here is a quick example of money illusion. Nick gets a 3% raise during a year when inflation is at 3.8% (as in 2008). Nora gets only a 1% raise during a year when inflation was actually a bit negative, such as in 2009. Who got the better deal? Most people would say Nick, whose nominal raise was three times that of Nora's. However, the real purchasing power of Nora's salary increased over 1%, while Nick's actually declined almost 1%. Despite getting a smaller nominal raise, Nora actually got a much better deal than Nick--it probably didn't feel that way.

People are just not very good at factoring in inflation as they think about their money over time. Gary Belsky and Thomas Gilovich give a couple of reasons for this in Why Smart People Make Big Money Mistakes: "First, accounting for inflation involves the application of arithmetic, which is often annoying and downright impossible for many people. Second, inflation today, at least in the United States, is an incremental affair--2 percent to 4 percent, on average, over the last decade and a half...little numbers are easy to discount or ignore."

Although it might be somewhat difficult, and the impact may seem small, accurate thinking about inflation is crucial in avoiding some big financial planning mistakes. Here are three areas where people commonly fail to consider the impact of inflation on their future:

Social Security is an inflation adjusted pension or annuity that most Americans will benefit from in retirement. Discussions are underway about the right methodology for determining future Social Security COLAs, and these changes will likely result in somewhat lower future inflation adjustments. However, even with some tweaks to the calculation, people should continue to receive tremendous value in having a basic foundation of inflation adjusted retirement income through the system.

Of course, we don't know exactly what inflation rates will be in the future, but we hopefully know enough to plan. Investors need to realize that there is a certain level of inflation expectations implicitly or explicitly built into the prices of stocks, bonds, and other investments. It is important to always consider the difference between the nominal return to investments, and the real return. Higher nominal rates of return may sound better, but real rates of return will determine your future lifestyle. The big risk to our financial plans is if inflation rates deviate significantly (up or down) from the somewhat low inflation expectations built into current stock and bond prices. Protecting yourself from both expected and unexpected inflation is a key objective of portfolio construction.

In later posts we will look at the Consumer Price Index--some of the controversy around it, and why your personal inflation rate may look very different from the averages.