The NorthPath Letter · Behavioural Finance · Afternoon Edition · 29 May 2026
The bias: a 1997 paper that named what Irving Fisher had already seen
The long-term equity investor’s relationship with money is supposed to be straightforward. A rupee, a euro, a dollar is a unit of account; capital is what it can buy. The portfolio is a claim on future real consumption, and only the real return — the return after inflation — matters for whether the investor’s family will retire comfortably, fund a child’s university place, or endow a charitable trust. None of this is controversial. It is taught in the first month of any finance course. And it is, for most investors most of the time, quietly ignored.
The bias that explains the gap between the textbook treatment and lived practice has a name. In May 1997 the Quarterly Journal of Economics published a paper titled simply “Money Illusion” by Eldar Shafir, Peter Diamond and Amos Tversky. Through a series of carefully designed surveys — on house purchases, salary negotiations, bonus framing and contract evaluation — the authors showed that ordinary people, including those with formal training, systematically evaluate transactions in nominal terms even when they have been told, explicitly, that the relevant comparison is the real one. The bias was robust, replicable across populations, and present in domains where the welfare consequences of getting it wrong were large.
The paper did not invent the concept. Irving Fisher’s 1928 book The Money Illusion, published in New York by the Adelphi Company, had defined the phenomenon as the “failure to perceive that the dollar, or any other unit of money, expands or shrinks in value” — a definition that has not been improved upon in the century since. What Shafir, Diamond and Tversky added was the experimental architecture: a way of demonstrating, in clean laboratory conditions, that even when both the nominal and real numbers were placed directly in front of the respondent, the nominal frame remained the dominant influence on the choice. Money illusion was not, in their account, a failure of arithmetic. It was a failure of representation — a deep feature of how the mind encodes value.
That distinction is what makes the bias important for the long-term equity investor. The horizon over which a portfolio compounds is precisely the horizon over which inflation does its work. A 6% nominal return at 2% inflation and a 9% nominal return at 5% inflation are economically the same trade; one feels much better. A pension pot that doubles in twenty years while the cost of living triples has shrunk in real terms by a third; the statement, in nominal currency, looks like a triumph. The bias the 1997 paper described is therefore the bias most likely to be active when the investor is reviewing the very horizon on which the strategy is built.
The mechanism: dual representation, with the nominal frame doing most of the work
Shafir, Diamond and Tversky proposed a specific cognitive architecture. People, they argued, hold simultaneous representations of economic quantities in nominal and real terms. Asked directly, in a vacuum, which representation is “correct,” most respondents will name the real one. But choices, judgements and emotional reactions are influenced by both representations, and the nominal representation tends to dominate because it is salient, simple, immediate and shared with everyone else who uses the same currency. The real representation requires an act of mental adjustment that the brain treats as effortful, optional and easily skipped under time pressure or affective load.
This dual-representation account has held up well under three decades of follow-on work. Replication studies — including a 2020 multi-country extension published in the Journal of Behavioral and Experimental Economics and a 2024 Brazilian replication in the same journal — recovered the core effects with consistent magnitudes. The bias is documented in wage negotiations (workers strongly prefer a 2% raise at 4% inflation to a 2% pay cut at 0% inflation, even though the real outcome is identical), in housing decisions (sellers anchor to the nominal price they paid, ignoring the price level that has moved beneath them), in bond evaluation (retail investors describe high-coupon bonds during inflationary periods as “safe income” even when the real coupon has gone negative) and, most importantly for the present subject, in equity returns (investors compare the index level today with the index level at purchase and call any positive number a gain).
The architecture also explains why money illusion is so resistant to education. Knowing that real returns are what count does not remove the nominal frame; it adds a second frame on top of it. Under deliberation, the educated investor can override the nominal reading. Under stress, fatigue or strong emotion — exactly the conditions in which most portfolio decisions are actually taken — the override fails, and the nominal frame wins by default. The 1997 paper did not phrase it this way, but the implication is unavoidable: money illusion is not solved by knowing about money illusion. It is solved, if at all, by building procedural defences that do the real-terms translation for the investor before the decision is taken.
The empirical record: regulators, surveys and three decades of measured loss
Two regulator anchors from two regions establish that the bias is neither academic nor historical. In the United States, the Treasury introduced Treasury Inflation-Protected Securities (TIPS) in January 1997 — the same year the Shafir-Diamond-Tversky paper appeared in print. TIPS exist precisely because nominal Treasury securities are not a complete instrument set for an investor who wants to express a view about real, rather than nominal, future cash flows. The Federal Reserve’s Survey of Consumer Finances and the long history of TreasuryDirect retail data confirm that even after a quarter-century of availability, retail allocation to TIPS remains a single-digit percentage of household fixed-income holdings, while retail allocation to nominal Treasuries and certificates of deposit has remained an order of magnitude higher. The instrument that solves the problem exists; the bias keeps most retail investors from using it.
In the United Kingdom, the Financial Conduct Authority’s Financial Lives 2024 survey put a sharp number on the same phenomenon for cash savings. Among UK adults holding at least £10,000 in cash but no investments, only 59% agreed with the statement that money held in cash savings decreases in value because interest rates usually do not keep pace with inflation. The remaining 41% — a population whose holdings, in aggregate, run into the hundreds of billions of pounds — either disagreed, were uncertain, or had never considered the question. The FCA’s Consumer Duty rules, in force since July 2023, and the new Consumer Composite Investments disclosure regime scheduled to replace the UK PRIIPs framework on 6 April 2026, both require firms to communicate the real-terms consequences of cash drag and inflation more clearly. The fact that such rules have to be written, and re-written, two and three decades after the academic work was complete, tells the long-term equity investor everything about how durable the bias is.
Academic measurement has converged on the same conclusion through a different channel. The work of Eugene Fama and others on the Fisher hypothesis, the long literature on the equity risk premium measured in real terms, and the regular monitoring of household real wealth by central banks all show the same gap between the nominal accounts that investors keep and the real accounts that ultimately determine their consumption. The accounts disagree most violently during inflationary episodes, when the nominal numbers are flattering and the real numbers are punishing. They disagree most quietly during disinflations, when the nominal numbers are flat and the real numbers are slowly improving — and the investor concludes, wrongly, that nothing is happening.
Two historical episodes: the 1970s US and the 2021-2024 global inflation
The 1970s in the United States are the canonical case. Between January 1972 and December 1981 the US Consumer Price Index rose by approximately 134%; over the same decade the S&P 500 price index rose by approximately 38%. Investors who looked at their statements saw nominal gains, modest dividends, and a portfolio that had not collapsed. Investors who priced their portfolios against the cost of the lives they were actually living saw something quite different: a real loss of roughly 40% in equity values, accompanied by a similar real loss in nominal bond portfolios. The decade was, for the long-term equity investor, one of the worst in the modern record. The nominal statements obscured it. Warren Buffett, in his May 1977 Fortune article “How Inflation Swindles the Equity Investor,” explained the mechanism: stocks, in economic substance, are perpetual instruments paying a real coupon, and inflation reduces that coupon both by raising the cost of the assets the business must replace and by raising the return required from competing securities. The piece is read today not as an investment recommendation but as the clearest contemporaneous diagnosis of money illusion in equity markets ever written.
The 2021-2024 episode supplies the modern counterpart. US CPI inflation, having been around 1.4% in January 2021, rose to a peak of 9.1% in June 2022 — the highest reading in four decades. Eurozone harmonised inflation peaked at 10.6% in October 2022. United Kingdom CPI inflation peaked at 11.1% in October 2022. India’s headline CPI inflation, while less extreme, averaged above the Reserve Bank of India’s 4% target throughout 2022 and into 2023. During the same three-year window most global equity indices delivered nominal returns that, viewed in isolation, looked respectable. Adjusted for the local cost of living, a substantial fraction of those returns disappeared. Cash deposits, money-market funds and short-duration nominal bonds — all of which appeared on retail statements as “safe” — delivered real returns that were, for an extended interval, materially negative. The fact that the bias was active in this episode, despite forty-eight years of accumulated academic and journalistic warning since the 1977 Fortune article, is the strongest available evidence that knowledge alone does not dissolve money illusion.
Howard Marks’s December 2022 Oaktree memo “Sea Change” is the practitioner reading of the same episode. Marks argued that the four-decade environment of disinflation and falling interest rates had ended, and that investors who had built mental models — and portfolio structures — calibrated to that environment would have to rebuild them for a regime in which positive real returns from credit instruments became possible again and the equity premium had to be re-earned. The memo’s importance for the present essay is that it framed the regime change explicitly in real terms. Most of the commentary it provoked, in the financial press and on retail platforms, did not.
The counter-measure framework: three disciplines that translate before the decision is taken
The bias is durable. The defences therefore have to be procedural rather than cognitive — built into the workflow of portfolio review, not into the goodwill of the reviewer. Three disciplines, in combination, do most of the work.
Discipline one — keep two sets of books and report on the real one first. Every periodic portfolio review should open with the real-terms account and only then turn to the nominal-terms account. The real account expresses the portfolio’s value, contributions and withdrawals in the units of a chosen base period (any base will do; consistency matters more than the choice). The deflator is published — for India by the Ministry of Statistics’ CPI series and the RBI’s WPI series; for the eurozone by Eurostat’s HICP; for the United Kingdom by the Office for National Statistics; for the United States by the Bureau of Labor Statistics’ CPI-U. The investor builds a spreadsheet, fills it monthly, and looks at the real column first. The simple act of putting the real number above the nominal number in the page layout removes most of the bias most of the time.
Discipline two — express every long-term target in real terms, and refuse to translate. The investor who says “I want my portfolio to fund €48,000 of annual spending in today’s purchasing power for 30 years from retirement” has stated a target the brain can verify against the real account. The investor who says “I want a portfolio worth €2 million” has stated a target the brain can hit nominally while losing real ground. The first form is harder to formulate, harder to communicate to a spouse, and harder to celebrate when reached, precisely because it is honest. The second form is easy, comforting and frequently wrong. The discipline is to write the target down in the first form, share it with the household in that form, and refuse — including to oneself — to translate it into a nominal headline. Where a nominal headline is unavoidable for administrative purposes (a will, a contribution limit, a tax declaration) the real-terms equivalent is recorded alongside it in the same document.
Discipline three — pre-commit to inflation-linked allocations as a structural, not tactical, position. The instruments exist. US TIPS, UK index-linked gilts (in issue since 1981), French OATi and OAT€i, Italian BTP€i, German Bund€i, Brazilian NTN-B, Chilean UF-linked deposits, Indian Inflation-Indexed Bonds: each is a direct claim on real, rather than nominal, future cash flows. The discipline is to decide in advance, in writing, what fraction of the long-term portfolio will be held in inflation-linked instruments and to hold to that fraction across regimes. The fraction will be wrong much of the time — inflation-linked instruments under-perform nominal ones during disinflations and the gap can persist for years — but the structural commitment removes the bias-driven temptation to abandon real-terms protection precisely when it begins to be needed. The 1997 paper’s central finding, that nominal evaluation dominates real evaluation under cognitive load, is the reason such commitments must be pre-written rather than left to in-the-moment judgement.
How long-term equity practitioners have addressed it
Benjamin Graham treated the question in the chapter on “The Investor and Inflation” in the 1973 fourth edition of The Intelligent Investor. Graham acknowledged the natural impulse to look at the dollar amount of a portfolio and to be satisfied with growth in that amount, and then insisted on a real-terms view: the investor’s purchasing power, not the dollar count, was the proper test of investment success. Graham did not use the modern psychological vocabulary; he treated the bias as an obvious error of accounting that the disciplined investor would simply refuse to make. The chapter remains, half a century later, the most concise statement of the real-terms discipline in the practitioner literature.
Warren Buffett’s 1977 Fortune article was a more explicit attack on the same problem at the level of the security rather than the portfolio. The essay defines the “equity coupon” — the real return generated by the underlying businesses — and argues that during inflationary periods the equity coupon is squeezed from both sides: by the rising cost of the fixed assets the business must replace, and by the rising returns available on competing instruments. The piece’s specific empirical claim, that the long-run return on equity was anchored near 12% nominal regardless of inflation, has been debated since; the diagnostic frame has not. Buffett returned to the theme in shareholder letters throughout the late 1970s and again, briefly, in the inflationary episodes of 2021-2023, restating the point in the language of owner economics: only the real change in the value of the underlying businesses matters; the inflation-adjusted accounts are the only accounts that tell the truth.
Howard Marks’s December 2022 memo “Sea Change” provides the contemporary practitioner reading. Marks argued that the long disinflation of 1982-2021 had produced a generation of investors whose mental models, portfolio structures and risk frameworks were calibrated to a falling-rate, low-inflation world. The regime change, in Marks’s account, was not a tactical opportunity but a requirement to rebuild those mental models in real-terms language. Where the memo is read carefully, the prescription is identical to Graham’s: maintain the real account, set the targets in real terms, and accept that inflation-linked allocations are a structural rather than tactical commitment. Three generations of long-term investors, each writing in the vocabulary of their own era, have produced, on the question of money illusion, the same framework.
Key takeaways
- The bias is one of representation, not arithmetic. Shafir, Diamond and Tversky’s 1997 paper showed that the nominal frame dominates even when the real numbers are placed in front of the respondent. Education alone does not remove it.
- The instrument set that solves the problem exists. TIPS (US, 1997), index-linked gilts (UK, 1981), eurozone OATi/BTP€i/Bund€i, Indian IIBs and inflation-linked deposits in several emerging markets are all direct claims on real, not nominal, cash flows. Retail allocation to them remains small.
- The 1970s and 2021-2024 are the same lesson, half a century apart. Nominal accounts looked acceptable in both episodes; real purchasing power eroded materially. The repetition is the proof that knowledge alone does not dissolve money illusion.
- The defence is procedural. Three disciplines — keep two sets of books and report on the real one first, state long-term targets in real terms and refuse to translate, pre-commit to inflation-linked allocations as a structural position — do most of the work because they take the real-terms translation out of the moment of decision.
- Graham, Buffett and Marks converged on the same framework. Three generations of long-term equity practitioners, writing in different decades and different vocabularies, produced the same prescription. Money illusion is the bias that long-term equity investing was, in part, invented to defeat.
— Manish Goel, FCA / NorthPath Advisory OÜ / Tallinn, Estonia
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