Julius Baer introduced its Lifestyle Index to gauge the price inflation of a basket of goods for our clients around the world – and with this data, investors can estimate what it takes in terms of portfolio returns to preserve, or even grow, their purchasing power. So what is the mirage of wealth – also known as money illusion?
My eldest son is a long-time follower of London-based Arsenal FC. If this year I give him GBP 50 to buy the 2020/21 official shirt, and next year I will give him GBP 60 – the club is a knowledgeable merchandiser and releases a new shirt every year – then my son will feel richer before entering the shop next year. He will expect to have an extra ten pounds to spend on other merchandise, only to find out that the price of the official shirt has risen to GBP 60, therefore negating his excess cash. His budget offers just enough money to buy only next year’s shirt, despite the 20 per cent increase in his purchasing power.
Economists label my son’s happy feeling before entering the shop as the ‘money illusion’. He feels richer because he has more money, but in reality he can only afford the same shirt. This is what many – in particular high-end consumers in most recent years – encounter when they buy the items they would like.
Whatever the category of purchase, the prices may rise in line with, or even greater than, what they can afford. The discrepancy between what they could buy last year and this year with the same amount of money is known as a ‘loss in purchasing power’. In the case of my son, if he only had GBP 50 again next year to buy the official team shirt, he would experience a loss of 20 per cent in his purchasing power.
Inflation is individual
Authorities try to capture changes in purchasing power by putting together a consumer basket that mimics average spending patterns. They then measure the prices year after year to estimate the exact loss, or gain, of purchasing power overall. This ‘price tag to basket’ measurement tool is called the Consumer Price Index, but it does not take into account individual preferences.
To stay with my example, my son’s younger brother, who supports Tottenham Hotspur, may find the price of the 2021 version of his favourite team shirt remains unchanged. So, for him, the extra ten pounds would be no money illusion and his real purchasing power would indeed increase. As for the overall consumer basket, this personal preference will go unnoticed unless sporting goods as a category increase in price. The same principle applies to all the items and goods measured in such a ‘one-size-fits-all’ index.
A targeted basket
How, then, can we more accurately measure the changing purchasing power for a more specific segment of the population? The effect of purchasing power on private wealth was taken into account early on by ‘Forbes’ magazine, which has been collecting figures that represent the ‘cost of living extremely well’ (see chart 1) since the 1980s. This gauge is meant to capture the living cost of the wealthy, which differs very much from the average consumer and therefore also from the overall consumer basket.
When looking at the US experience over the past 40 years or so, the difference from official inflation statistics is stunning. While annual inflation was less than 3 per cent on average for the ‘normal’ consumer, for the wealthy it was almost 5 per cent. For consumers interested in managing, maintaining, and indeed growing personal wealth, individual cost increases make all the difference to your budget – regardless of how big your budget is.
The compounding of these price increases shows the staggering erosion of purchasing power. If a ‘normal’ consumer held all their money in cash over the past 40 years, their purchasing power would have halved roughly every 23 years on average. Yet for the wealthy, halving their purchasing power has only taken 13 years, so the USD 100 that bought the ‘luxury basket’ in 1982 would only buy a tenth of that today.
Managing money against your cost of living
In order to preserve and hopefully improve your purchasing power, you need to understand what is needed to achieve this goal. This is where both a good wealth management strategy and our Index come into play. Our Index sets a benchmark for the portfolio returns individual clients need to achieve to meet or surpass their rising costs of living.
We have been performing this task for our Asian clients over the past decade in the Wealth Report Asia, and take a closer look at the region in the next article. Last year, we extended this analysis to cities around the world to create the Global Wealth and Lifestyle Report, to help our clients worldwide to better understand their local inflation rate and factors that might
affect their purchasing power.
For anyone looking to stem the constant erosion of their wealth in real terms, understanding their purchasing power is an important first step. By combining a good knowledge of local inflation rates with the right wealth management and wealth preservation strategies, they should be able to continue living in the manner to which they are accustomed far into the future, while preserving their wealth for the next generation.
Global Wealth and Lifestyle Report 2021
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