The Stock Market: A Theater of Illusions

Do you remember that time when you got your first raise and felt like the king of the world, only to realize that prices had also gone up?

That's kind of what we call the money illusion. Essentially, it's our tendency to confuse nominal amounts (those expressed in good old clinking and clanking USD) with real amounts (which account for inflation, so your actual purchasing power).

Now, let's take a look at the stock market scene. Imagine you're front and center at a magic show where stocks are the magicians and inflation is the assistant who can either make the act spectacular or let it fall flat.

• Act 1: The Inflationary Shock
  After an inflation announcement, the immediate reaction is often a drop in stock prices. Investors, much like disappointed spectators, tend to underestimate future real returns, relying too much on nominal figures. Result? A drop of 2 to 4% on average. Applause is sparse.

• Act 2: The Comeback
  But wait! Act 2 has its share of surprises. Over time (say 3 to 6 months), this drop tends to even out, and real returns skyrocket, showing a nice +1 to +3%. The magicians get their mojo back, and the audience smiles again.

• Act 3: The Grand Finale
  In the long run (1 year), the situation is more nuanced. Some acts dazzle, others disappoint. Some studies show a neutral or even slightly positive impact, others talk about a persistent negative effect. And like any good show, the impact varies depending on the context: an inflationary shock during a period of low inflation creates more of a stir than during an already inflationary period.

If the money illusion were an artist, it would be skilled at making the audience laugh and cry simultaneously. But as in comedy, in the stock market, one should laugh at the tricks inflation and stock returns play on us, while learning to decode them so as not to end the session in tears.

And you, will you let the money illusion cloud your vision, or will you learn to see beyond appearances to grow your precious USD?

A good way to keep the illusion in its rightful place (fiction) is to automate. 

Personally, that's what I try to do as much as possible, and I have some recent research to share with you on this subject.

Antoine

PS: The scientific study from which the figures are derived https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1137898