Investment manager, Chris Sutton, explains ‘The Illusion of Money’, in other words, the fact that most of us view our wealth and income in money terms.
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The illusion of money is a term that was first developed by the American economist, Irving Fisher, during the late 1920s and popularised by the British economist, John Maynard Keynes.
The illusion of money refers to the fact that, when thinking about wealth or income, most of us think of it in its monetary terms. In doing so, we are mistaking the face value of money for its purchasing power – what we can actually use that money to buy. That is going to be affected by inflation.
So, when we think about cash or investments, we need to think not just of the monetary value of return, but the return after adjusting for inflation This is what we call the inflation adjusted or real return.
It has been possible to get 4% or even 5% interest return on cash in the UK, but we have also seen UK inflation running at over 7%. This means that while the money return on cash is at the highest level for almost 15 years, it is still producing a negative real return after we take into account of inflation. And in fact the real return on cash in the UK at present is at its lowest level at any time over the last 30 years.
Now that does not mean that cash will not form a part of most individual’s and household’s wealth. Cash has a number of important functions, including as a rainy-day reserve in the face of unexpected expenditure. But it does highlight the direct relationship between inflation and interest rates, and the reason why cash will typically struggle to protect the value of wealth against the effects of inflation.
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