Are You Under the Money Illusion?

The value of money is constantly changing. A dollar today was worth five times as much as in 1970. And it may only be worth half as much twenty years from now.

Despite a widespread disdain for inflation, however, I've found that few people genuinely understand it. While most see prices rising, they assume the dollar's value stays the same. The famous economist Irving Fisher called this the "money illusion" -- our failure to perceive that the value of money fluctuates and not the price of things we buy.

While this distinction seems trivial at first, it makes an enormous difference over the long-run -- as inflation can completely cancel out otherwise respectable investment returns. My purpose in this column is to help readers come to grips with the money illusion, and to explore some specific ways to protect their portfolios against its otherwise pernicious effects.

The Money Illusion
The money illusion often only affects one's view of their home currency. Recently, our newspapers have covered the Euro's decline, how Japan and Switzerland are struggling against increasingly strong currencies, and how China is slowing appreciating the value of the Yuan. Yet rarely do we assume these movements could be caused by fluctuations in the dollar's value, which many of them arguably are.

Fisher offered an example of this in his book The Money Illusion. The value of the German mark decreased demonstrably between the First and Second World Wars. At one point, a mark was worth only 1/50th of its original value. Yet after interviewing 24 German men and women, Fisher discovered that only one had any idea the mark's value had actually changed. The others attributed the price increases to the supply and demand for goods, the destruction wrought by the war, a perceived conspiracy by America to corner the world's gold market, and so on.

While the example of Germany after the First World War is extreme, the same principles apply today. Just last week, I was lamenting the price of movie theater admission. My wife and I spent $20 for two tickets to a matinee. The same thing would have cost $10 when I was growing up, and less than $1 in my grandfather's day. Could it be that the demand for movie admissions relative to supply has doubled in my lifetime and increased by a multiple of 20 in my grandfather's? The answer, of course, is "no" (or maybe it has, but that's not the reason price increased). What's changed is the value of the dollar. As you can see in the table below, the purchasing power of the dollar has decreased consistently since 1940.

Source: MeasuringWorth.com.

Application to investors

While the money illusion seems most applicable to consumers, I'd argue it's even more important that investors understand its significance, as investing is the only way to protect future purchasing power. Let me give you an example. Say you have $100,000 in cash and are choosing between buying super-safe 30-year treasury bonds currently yielding 3%, a stock that yields 3% and appreciates in value 3% a year, or simply leaving the money in cash. Assuming a 3% annual inflation rate, the following table shows the purchasing power of your original $100,000 after 30 years.

Source: Author's calculations.

In other words, the only way to ensure your $100,000 is worth at least that amount in the future, is to invest it. And ideally in a way that will increase its purchasing power.

In terms of simply protecting your money's value, the easiest way is to purchase Treasury Inflation-Protected Securities, or TIPS, through the iShares Barclays TIPS Bond Fund (NYSE: TIP). The principal of TIPS increases with inflation and decreases with deflation. When TIPS mature, you are paid the greater of the inflation-adjusted principal or the original principal.

A second option is to invest in companies based abroad. The iShares FTSE China 25 Index Fund (NYSE: FXI) owns a wealth of interesting companies in the world's most populous nation. China Mobile (NYSE: CHL), an investment holding company that provides mobile telecommunications and related services to mainland China, has huge potential in a growing telecom market that's hungry for more and faster services. Similarly, CNOOC (NYSE: CEO) is the third-largest oil and gas company in China and stands to profit by fueling middle-class growth in the emerging economy.

Sticking closer to home, I like strong dividends from consumer stocks. My current preference in the sector is Procter & Gamble (NYSE: PG), which has pricing power stemming from its strong brands. The short-term downside is limited by vast global diversification. The long-term upside is supported by a global population that's growing in both wealth and size. And it pays a respectable 3.2% dividend yield.

One more great company

Beyond these four, the one final company that I'd recommend to maintain your purchasing power is disclosed in our recently released free report, "The Motley Fool's Top Stock for 2012." It profiles an under-the-radar company being billed as "the Costco of Latin America." Needless to say, the upside to this company is phenomenal. To learn the identity of this company before the market catches on and sends its share price soaring to new heights, click here now -- it's free.