Money illusion in trading psychology: nominal vs real returns

Money illusion is the tendency to think about money in nominal terms – the number you see on a payslip, account balance, price chart or P&L statement – rather than in real terms, which account for inflation. For example, a 5% pay rise during a period of 5% inflation may feel like an increase, even though purchasing power has not changed.

In financial markets, money illusion can affect how investors and traders read returns, compare historical prices, and judge the real cost of trading. It does not mean someone misunderstands inflation. Instead, it shows how easy it is to focus on the number in front of you, without adjusting for what that number can actually buy.

This guide explains where money illusion comes from, how it can appear in market behaviour, and why real-value framing matters when reviewing trading performance over time.

What is money illusion?

Money illusion is a cognitive bias that occurs when people respond to the stated value of money rather than its real purchasing power. In simple terms, it means treating £100 today as if it means the same thing as £100 several years ago, even if inflation has changed what that money can buy.

Economist Irving Fisher first named and described the concept in his 1928 work The Money Illusion. Fisher argued that people often make financial decisions as if the value of money were stable, even when prices are changing around them (Investopedia, 4 February 2026). This matters because wages, savings, prices and investment returns are usually shown in nominal terms.

The illusion is not the same as being unaware of inflation. Research by Eldar Shafir, Peter Diamond, and Amos Tversky (1997) found that even people who understand inflation may still judge economic outcomes in nominal terms. This happens because nominal values are easier to see and process. Real values require an extra adjustment step, which takes more effort and is easy to skip (Oxford Academic, 1997).

Origins and development of money illusion

Fisher’s original idea focused on the wider economy. He looked at how money illusion could affect wages, prices and business cycles. For example, workers may resist a pay cut even when falling prices mean their real purchasing power is stable. They may also accept a pay rise that feels positive, even if inflation removes the real benefit.

Keynesian economists later used the concept to help explain why wages and prices may adjust slowly after economic shocks. If people focus on nominal changes, they may react differently to a pay freeze, a pay cut or a price rise, even when the real outcome is similar.

The idea became more important in behavioural economics after Shafir, Diamond, and Tversky’s 1997 paper in the Quarterly Journal of Economics (Oxford Academic, 1997). Their research showed that people often judge gains, losses and fairness in nominal terms, even when they have enough information to adjust for inflation. This connects money illusion to broader ideas in trading psychology, including anchoring, framing effects and prospect theory.

Franco Modigliani and Richard Cohn later applied money illusion to stock market valuation. Their 1979 research argued that investors may undervalue equities during high-inflation periods if they use nominal interest rates to value real corporate earnings (Taylor & Francis Online, 2018). This suggests money illusion can affect both individual decisions and, in some cases, market-level pricing (NBER, 1979).

Key principles of money illusion

Money illusion can show up in three related ways: through the numbers people anchor to, how they react to gains and losses, and how wages and prices feel in different inflation environments.

Nominal anchoring

• Nominal values can act as anchors. When people judge whether they are better or worse off, whether a price is high or low, or whether a return is acceptable, the first number they see often becomes the reference point.
• In trading, that reference point may be an entry price, an account balance, a past high, or a reported return. Adjusting for inflation means stepping back and asking what that number means in real terms. Without that step, nominal figures can influence judgement more than their real economic value should.

Asymmetric illusion across gains and losses

• Money illusion can affect gains and losses differently. A nominal gain may feel positive even when inflation means the real result is weaker. A nominal loss may feel more painful than a real-value comparison would suggest.
• For example, a portfolio that rises 4% during a period of 6% inflation has lost value in real terms. However, the account balance still shows an increase, which may make the outcome feel better than it is. This is one reason traders and investors may overestimate performance when they only look at nominal returns.

Wage and price rigidity

• At the economic level, money illusion can contribute to wage and price rigidity. People may be more comfortable with a pay freeze during low inflation than with a pay cut during deflation, even if both outcomes have a similar effect on purchasing power.
• This matters for traders because inflation changes how historical prices and returns should be read. A price, wage or return from a different period may not be directly comparable unless purchasing power has also been considered.

Money illusion in financial markets

One of the main market applications of money illusion comes from Modigliani and Cohn’s 1979 hypothesis. They argued that stock market investors may undervalue equities during inflationary periods by using nominal interest rates to assess real future earnings.

The issue is the mismatch. If future cash flows are real, but the discount rate includes an inflation premium, the valuation may understate the real value of those cash flows. This does not mean inflation always leads to undervaluation, but it gives one explanation for why inflation and equity valuations can interact in complex ways.

Later research, including Campbell and Vuolteenaho (2004), found evidence that is consistent with parts of this idea (American Economic Association, 2004). However, the relationship is still debated (NBER, 2004). Inflation can affect markets through many channels, including interest rates, earnings expectations, risk appetite and economic growth (U.S. Bank, 2025). Money illusion is one possible factor, not a complete explanation.

Money illusion and trader behaviour

Money illusion can affect trading decisions in practical ways, especially when traders review performance, costs and entry prices without adjusting for inflation.

Misreading nominal P&L as real return

For active traders, money illusion can appear in the way P&L is read. A trader who makes a 3% nominal return when inflation is higher than 3% has lost purchasing power in real terms. The account may still show a positive result, but the economic outcome is weaker once inflation is considered. Over time, this can affect how traders judge performance. It may also influence decisions about position sizing, reinvestment, and whether a strategy is meeting its intended objectives.

Underestimating the real cost of spreads and fees

Trading costs, including spreads, overnight financing charges, and commissions where applicable, are usually shown in nominal terms. That makes them easy to identify, but it can also make their real effect harder to judge. For CFD traders, this matters because costs can affect performance over time. A small nominal cost may still be meaningful when compared with the trader’s real return after inflation. This is particularly relevant in high-inflation environments, where the gap between nominal and real outcomes can widen.

Anchoring to purchase price in nominal terms

Traders often remember entry prices clearly. That can be useful for reviewing trades, but it can also create an anchor. If a position was opened when inflation was lower, the real value of that entry price may have changed. A current price may need to move above the original entry price simply to match the same real purchasing power. Without that adjustment, a trader may misread the true break-even point in economic terms.

Applying money illusion to CFD trading

In CFD trading, money illusion can affect how traders assess performance, costs, and risk.

One practical step is to apply a real-return perspective. When reviewing trading performance during a period of significant inflation, traders can compare nominal P&L with purchasing-power change. This gives a clearer view of whether the result has improved real economic value. It does not usually require a complex calculation: a reasonable inflation estimate applied to the relevant period can be enough to reframe the result.

A second consideration is the real cost of leverage. CFD financing charges are nominal costs applied to a nominal position size, but the real cost depends on both inflation and interest rates. In a high-inflation period, inflation can reduce the real value of debt. However, central banks may also raise interest rates in response to high inflation, which can increase nominal overnight financing charges. The net real cost depends on the specific rate environment, so it should not be assumed to be lower just because inflation is elevated.

A third consideration is cross-period comparison. When reviewing historical trades, backtests or price data, traders may draw misleading conclusions if they compare nominal figures from different inflation environments. A return that looked strong in one period may look weaker after inflation. A price that looked high or low in the past may not carry the same real meaning today.

Criticisms and limitations of the money illusion concept

Money illusion is a useful behavioural concept, but it has limits. These criticisms help show when the idea is most relevant, and when traders may need to look at other explanations too.

• Rational inattention: some economists argue that what looks like money illusion may sometimes be a practical shortcut. In small everyday transactions, adjusting every price for inflation may take more effort than it is worth. However, real-value adjustment becomes more relevant when decisions involve larger sums, longer timeframes, trading performance or higher costs.
• Limited market-level evidence: the Modigliani-Cohn hypothesis remains debated. Some research supports the idea that money illusion can affect aggregate market pricing, while other research points to more direct factors such as earnings, interest rates, growth expectations and risk premia. This means money illusion should not be treated as a single explanation for market movements.
• Context dependence: money illusion may be stronger or weaker depending on the inflation environment. In countries with chronic high inflation, people may be more used to adjusting for purchasing power. In low-inflation environments, nominal and real figures can feel similar for long periods, making the bias easier to overlook.

Common misconceptions about money illusion

Money illusion is often misunderstood. These points clarify who it can affect, when it matters, and why inflation adjustment helps but does not remove the bias entirely.

• Only less experienced investors fall for it: money illusion can affect traders and investors at different experience levels. Research suggests that even people with economic knowledge can default to nominal thinking, especially when balances, prices and returns are presented without inflation adjustment.
• It only matters during high inflation: high inflation makes money illusion easier to spot, but lower inflation can still make a difference over time. Even 2–3% a year can compound, meaning a five-year trading record may look stronger in nominal terms than it does after cumulative inflation.
• Adjusting for inflation solves it: inflation adjustment helps, but nominal values usually remain the default in account balances, trading platforms, prices, tax records and reports. Reducing money illusion usually means building a habit of asking whether a figure should be read in nominal terms, real terms, or both.

Overall, money illusion is not just a beginner’s mistake or a high-inflation problem. It is a framing bias that can affect how financial information is read, especially when nominal figures are easier to see than real purchasing-power changes.

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