Money Illusion and Anchoring are cognitive phenomena that impair the ability of many of us to understand how the value of money changes over time and, as a result, also impair our ability to negotiate a fair rate of pay for ourselves. The impacts of these phenomena grow over time – meaning, we are likely to undervalue ourselves by greater and greater amounts as our careers progress! These phenomena amplify the lack of information about how much our incomes need to grow to Stay Even by creating an additional downward bias in how we value ourselves.
Money Illusion is a focus on nominal amounts of money instead of real. That is, thinking about $100 today as largely the same as $100 ten or fifteen years ago, instead of taking into account how much inflation (and productivity growth) has eroded the value of our $100 bill. Example: $100 you may have earned in the year 2013 was worth much less than $100 earned a few years ago, in the year 2000. How much less? According to government-published inflation statistics, you would have needed $135 today to equal your $100 bill of the Year 2013. According to the Staying Even Index, you would have needed $145 in 2013 to replicate the value of that 2000 $100 bill. So, if you think of $100 as an amount today in somewhat the way you did a few years ago, you are overestimating its value.
Money Illusion is valued by business owners and economists for the very reason it is dangerous to individuals– it allows employers to “appear” to give employees raises, when in reality they may be paying the same or less once we account for inflation. The Investopedia definition (as of this writing) is very clear on this:
Having small levels of inflation allows employers, for example, to modestly raise wages in nominal terms without actually paying more in real terms. As a result, many people who get pay raises believe that their wealth is increasing, regardless of the actual rate of inflation.
That’s right – economists say Money Illusion is good because it allows you to get fooled! Well we say it is bad because it allows you to get fooled!
Anchoring is a separate but related concept that suggests that people "anchor" on numbers, whether dollars or other things – based upon our first exposure to them. For a non-money example, think about oil changes. Many of us grew up with 3,000 miles as the basic guidance for an oil change – and many of us have a hard time giving that up even though automakers now often say that 7,500 miles is just fine. We have anchored on that earlier number and struggle to move off of it. In money terms, we may remember our first salary or what we thought was a lot of money when we were children – and that anchor is hard to update even though times have changed – $20 an hour used to seem like a lot of money? Well it’s not so much anymore but we may in our mind have a hard time moving off that anchor and be satisfied with wages that because we have anchored seem "high enough" for the work we are doing.
Anchoring and money illusion are two similar concepts that amplify each other by potentially causing us to believe that over time we are doing financially better than we really are. And, the longer we work and earn money, the greater of an impact these phenomona have on us! If we think about money in nominal terms and are anchored in the past, we will under-negotiate for ourselves. We’ll settle for $15 an hour instead of the $20 that the market might bear. Or, we'll settle for an $80,000 salary instead of $100,000. We will fall right into the trap the economists have laid – believing we are making progress when we are maybe falling behind or just staying even.
The Staying Even Index is designed to help us fight these cognitive biases – by showing how much we need to earn over time to just stay even and how much to get ahead over time.