Money illusion: confusing nominal returns with real wealth creation
An investor whose portfolio earned 7% in a year when inflation ran at 5% feels they have made progress. The realised gain in purchasing power is 2%, not 7%. Money illusion—the systematic tendency to think in nominal rather than real terms—is the cognitive failure to make this adjustment, and the cumulative cost over a working life is large enough to determine whether retirement plans succeed or fail.
What money illusion is
Money illusion is the documented cognitive bias of evaluating monetary outcomes in nominal rather than real terms. Shafir, Diamond, and Tversky (1997), in Money Illusion, formalised the bias and demonstrated its operation across many decision contexts: wage negotiations, price perception, investment evaluation, and economic policy preferences. The pattern is universal—it operates on professional economists as well as retail investors—but it is most consequential where the nominal-real gap is largest.
The bias is closely related to but distinct from optimism bias and overconfidence. Money illusion is specifically about the unit of measurement: an investor evaluating a 7% nominal return in a 5% inflation environment understates the real progress because they treat the nominal figure as a measure of real wealth creation. Optimism would also overstate expected returns; money illusion overstates the meaning of any given realised return.
The bias is most pronounced in regimes where inflation is materially different from zero. Through the post-1990 period of generally low inflation, money illusion has been a smaller drag on investor decisions than it was during the 1970s. The 2022–2023 inflation surge brought the bias back into salience.
How it manifests in investing
The most direct manifestation is the over-evaluation of nominal returns in inflationary regimes. An investor whose portfolio gained 50% nominally over five years in which cumulative inflation was 30% has gained approximately 15% in real terms—but the nominal figure feels much more impressive than the real figure. The investor is more likely to maintain their savings rate and risk allocation based on the nominal feeling than they would based on the real reality.
A second manifestation is in the evaluation of fixed-income returns. A bond yielding 6% in a 5% inflation environment is delivering approximately 1% real return—close to zero. Investors who think of the 6% as the relevant figure systematically over-allocate to fixed income in inflationary regimes and under-allocate in disinflationary ones. The pattern produces persistent misalignment between the portfolio and the actual wealth-creation objective.
A third manifestation is in retirement planning. An investor planning to spend USD 80,000 per year in retirement may build a portfolio sized to deliver USD 80,000 of nominal income—without adjusting for the inflation that will erode the real value of that nominal figure over the 25–30 years of retirement. The same nominal income at the start of retirement is worth half as much in real terms 25 years later at 3% inflation; the planning that ignores the adjustment produces a meaningfully under-funded outcome.
The cost
The cost of money illusion is the cumulative gap between the nominal-frame decisions and the real-frame decisions that would have been optimal. The Dimson, Marsh, and Staunton long-run data shows that nominal returns on equities have averaged approximately 8% per year globally over the past century, while real returns have averaged approximately 5%. The 3-percentage-point gap is the long-run inflation rate and is the size of the money illusion error in equity-return evaluation.
Compounded over a 40-year working life, the gap between nominal and real wealth accumulation is large enough to determine whether retirement plans succeed. An investor who saves 10% of income on the assumption of 8% nominal returns and lives in a 3% inflation environment is implicitly building a portfolio whose terminal real value is much smaller than the nominal-frame planning suggests. The under-saving produced by the nominal frame is meaningful and accumulates over decades.
The cost is most acute in the decades when inflation is materially different from its long-run average. The 1970s decade of high inflation produced systematic under-performance for investors who maintained the nominal-frame thinking that had served them well in the disinflationary 1960s. The post-2010 disinflationary period favoured nominal-frame thinkers; the 2022 inflation surge has begun to penalise them again.
What helps
The structural remedy is to evaluate returns in real terms whenever possible. Reporting and analysing performance against an inflation-adjusted benchmark—most commonly an inflation-linked bond series—provides the comparison that the nominal frame obscures. The mental shift takes effort but the cognitive habit is learnable.
For systematic investors, the implication is that historical performance figures should be reported and evaluated in real terms whenever long-horizon comparisons are being made. A backtest comparison of two strategies over 1970–2025 in nominal terms is meaningfully misleading because the nominal scaling differs across decades; the real-terms comparison is the analytically sound version.
Money illusion in pfolio
pfolio reports nominal returns directly from the price series. Real-return analysis—essential for distinguishing genuine wealth creation from inflation—can be performed by setting an inflation-linked benchmark in the benchmark configuration. The cumulative gap between nominal and real returns over long horizons is the cost of money illusion.
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