Money illusion is an economic theory that suggests that people think in terms of absolute dollar values rather than real purchasing power. This happens because inflation and currency value changes aren’t always factored into decision-making—an oversight often explored in trading psychology.
A common example of a Money Illusion in everyday life is salaries. If you receive a 5% pay raise but inflation is running at 6%, your real wages and prices have actually decreased. Yet, many people feel wealthier simply because their income in nominal dollar terms has increased.
Money illusion stands as one of the most deceptive psychological traps in trading, leading investors to focus on nominal returns while ignoring the crucial impact of inflation. The idea was proposed in a seminal 1979 paper which supported the hypothesis that stocks are systematically mispriced when inflation is high. This aligns with the Modigliani-Cohn hypothesis, which suggests that the stock market suffers from money illusion during periods of inflation.
Let’s say that the S&P 500 index rose by 15%, but inflation ran at 8%. Traders will celebrate their gains without recognizing that their real value increased by only 7%. This cognitive bias distorts not just profit perception but fundamental trading decisions across all market sectors.
How Money Illusion Impacts Trading Decisions
Money Illusion affects stock traders in several ways:
Overvaluing Gains Without Adjusting for Inflation
Many traders celebrate a stock going from $50 to $55, believing they’ve made a 10% return. But if inflation is 8%, their real return is only 2%. Traders who ignore inflation might think they’re growing their wealth and income in nominal terms when, in reality, they’re barely keeping pace with rising costs. This inflation illusion can lead to poor financial decisions.
Comparing Stock Prices Without Context
A trader might hesitate to buy a stock at $100, believing it is “expensive,” while another stock at $10 seems “cheap.” However, without evaluating consumer price index adjustments, earnings growth, or macroeconomic policy, this thinking is misleading. A $100 stock could be undervalued, while a $10 stock might be overpriced junk. Stock market efficiency relies on adjusting for the effect of inflation in valuations.
Anchoring to Past Prices Without Adjusting for Inflation
Some traders refuse to buy a stock that used to be $30 but is now $50, believing it’s “too expensive.” They fail to take inflation into account, economic growth, and earnings increases that justify the higher price. This is a classic example of price stickiness where traders fail to adjust their expectations.
False Sense of Portfolio Growth
A portfolio that grows in nominal terms may not be growing in real terms. If a trader’s account grows from $50,000 to $55,000 in a year, they might feel successful. But if inflation is high, the real wages of their portfolio might not have increased much at all. Nominal rather than real values can deceive traders into overestimating their financial success.
Misjudging Market Trends
When central banks print money (monetary policy), stock prices tend to rise. That is not always due to strong company performance but because more money is chasing the same assets. Traders influenced by Money Illusion might misinterpret these movements as genuine growth and enter trades based on flawed assumptions. John Maynard Keynes noted that traders must adjust their expectations based on real aggregate demand rather than nominal prices.
The Role of Trading Systems in Mitigating Money Illusion
Systematic trading helps traders avoid Money Illusions by enforcing objective, data-driven decision-making. Here’s how:
- Systematic Position Sizing Eliminates Psychological Bias: Position sizing strategies ensure that traders don’t fall into the trap of thinking of nominal value rather than real value. Instead of buying “x shares” at a specific price, systematic traders allocate a fixed percentage of their portfolio, removing emotional reactions to price levels. This enhances market efficiency and reduces price illusion.
- Backtesting Proves What Works (Without Bias): Backtesting historical data under different rates of inflation conditions helps traders see the real performance of a system, preventing them from falling for the illusion of “nominal” gains. This is a fundamental principle of monetary economics.
- Rule-Based Trading Prevents Emotional Price Anchoring: A well-defined trading system generates buy and sell signals based on data, not emotions. This prevents traders from hesitating due to perceived “high” or “low” prices.
- Inflation-Adjusted Metrics Improve Performance Advanced traders integrate understanding money illusion into their analysis, ensuring their trading strategies remain effective even in changing economic conditions.
Challenges Systematic Traders Face with Money Illusion
Even systematic traders must actively guard against Money Illusion. Common challenges include:
- Adjusting Backtesting for Inflation: Many traders backtest systems without considering inflation’s impact over time. A system that works in low-inflation environments might struggle when inflation is high.
- Interpreting Market Trends Objectively: System traders need to ensure they’re not mistaking inflation-driven market moves for genuine growth. This requires monitoring real interest rates and economic indicators.
- Staying Disciplined When Prices Seem “High”: Even experienced traders can hesitate to enter a trade if a stock “feels expensive.” A well-tested trading system removes this hesitation by relying on data rather than price anchoring.
Actionable Tips for Overcoming Money Illusions in Systematic Trading
To protect your trading from Money Illusion, follow these practical steps:
- Use Inflation-Adjusted Returns: Compare your trading returns against real (inflation-adjusted) returns rather than nominal values.
- Stop Thinking in Dollar Terms. Use Percentages: Focus on percentage changes and relative performance, not absolute dollar figures.
- Apply Robust Backtesting Across Different Market Conditions: Ensure your trading strategy has worked in both high and low inflation periods. Learn more about trading system development.
- Follow a Rule-Based System (Not Gut Feelings): A defined system removes the impact of psychological biases like Money Illusion.
- Track Your Real Purchasing Power: Consider what your portfolio can buy over time, not just its nominal value.
Frequently Asked Questions about Money Illusion in Trading
1. How do I know if Money Illusion is affecting my trading?
If you frequently judge stocks by absolute price instead of nominal and real valuation metrics or hesitate to buy a stock because it means the employee “feels expensive,” you might be falling for the Money Illusion. Money illusion refers to misinterpreting market prices due to inflation expectations.
2. What tools can help me adjust for inflation in my trading?
Using consumer price calculators, inflation-adjusted backtests, and economic indicators like CPI can help you see beyond the face value of your money movements. The Journal of Economic Studies published by Oxford University Press highlights methods for tracking real returns.
3. Can systematic trading fully eliminate the Money Illusion?
While systematic trading reduces Money Illusion, traders still need to stay aware of factors such as a lack of inflation’s impact on backtesting, market trends, and real portfolio growth. Modigliani and Cohn discussed how inflation can distort financial expectations.
4. Should I trade differently in high vs. low inflation periods?
Yes. Some strategies work better in low inflation (e.g., growth stocks), while others excel in high inflation (e.g., commodity stocks). Adjust accordingly based on expected inflation and nominal interest rates.
5. How does Money Illusion impact long-term investing?
Long-term investors who focus only on wealth are increasing, in nominal terms, the risk of underestimating inflation’s effect. This can lead to an understanding of how inflation impacts real returns. Inflation leads to misinterpretations of asset pricing and financial decisions.
Conclusion: Trust Your System, Not Your Emotions
Money Illusion is a hidden trap that distorts how stock traders perceive gains, losses, and value. By relying on a systematic, data-driven approach, traders can eliminate emotional biases and make better decisions. Money illusion helps explain why traders often misinterpret inflation on stock performance.
At Enlightened Stock Trading, we help traders eliminate psychological biases and build unwavering trust in their trading approach. With The Trader Success System, you’ll develop confidence in a portfolio of proven systems, freeing yourself from the traps of money illusion vs real investing.
To learn more about how our program can help you overcome psychological biases and achieve lasting trading success, apply and join The Trader Success System today.
Trading Psychology and Psychological Bias Articles
To dive deeper into how other psychological biases affect your trading psychology and decisions as well as practical ways to overcome them, explore the articles below. For a comprehensive guide on mastering your mindset and building a resilient psychology, visit our Trading Psychology page.
- Action Bias in Trading
- Ambiguity Aversion in Trading
- Anchoring And Adjustment in Trading
- Anchoring Bias in Trading
- Authority Bias in Trading
- Availability Heuristic in Trading
- Bandwagon Effect in Trading
- Bias Blind Spot in Trading
- Choice-Supportive Bias in Trading
- Commitment And Consistency Bias in Trading
- Confirmation Bias in Trading
- Conservatism Bias in Trading
- Contrast Effect in Trading
- Decoy Effect in Trading
- Disposability Effect in Trading
- Disposition Effect in Trading
- Dunning-Kruger Effect in Trading
- Endowment Effect in Trading
- Escalation Of Commitment in Trading
- Familiarity Bias in Trading
- Framing Effect in Trading
- Gambler's Fallacy in Trading
- Halo Effect in Trading
- Herd Mentality in Trading
- Hindsight Bias in Trading
- House Money Effect in Trading
- Hyperbolic Discounting in Trading
- Information Bias in Trading
- Loss Aversion in Trading
- Money Illusion in Trading
- Narrative Fallacy in Trading
- Neglect Of Probability in Trading
- Normalcy Bias in Trading
- Optimism Bias in Trading
- Ostrich Effect in Trading
- Outcome Bias in Trading
- Overconfidence Bias in Trading
- Paralysis By Analysis in Trading
- Pessimism Bias in Trading
- Recency Bias in Trading
- Regret Aversion in Trading
- Representativeness Heuristic in Trading
- Salience Bias in Trading
- Selective Perception in Trading
- Self-Attribution Bias in Trading
- Status Quo Bias in Trading
- Sunk Cost Fallacy in Trading
- Survivorship Bias in Trading
- Trading Psychology in Trading
- Zero-Risk Bias in Trading
