Does Money Illusion Delude Investors?

45 Pages Posted: 8 Apr 2019 Last revised: 24 May 2019

See all articles by Yuna Heo

Yuna Heo

Rutgers Business School - Rutgers University

Date Written: March 10, 2019

Abstract

This study investigates the role of money illusion in a broad set of anomaly-based strategies. To the extent that anomalies reflect mispricing, I examine whether money illusion predicts anomaly returns. I find that, following periods of high inflation, anomalies are stronger and returns in short leg portfolios are lower. However, following periods of deflation, returns in short leg portfolios are not lower and long-short strategies are not profitable. These findings indicate that money-illusioned investors excessively extrapolate the upside potential of stocks in short leg portfolios following periods of high inflation and, subsequently, experience negative returns. I find the effect of money illusion to remain largely unchanged after controlling for sentiment. Overall, this study presents evidence that money illusion leads to mispricing in the stock market.

Keywords: Money Illusion, Inflation, Mispricing, Extrapolation, Return Predictability

JEL Classification: G02, G12, E31

Suggested Citation

Heo, Yuna, Does Money Illusion Delude Investors? (March 10, 2019). Available at SSRN: https://ssrn.com/abstract=3353245 or http://dx.doi.org/10.2139/ssrn.3353245

Yuna Heo (Contact Author)

Rutgers Business School - Rutgers University ( email )

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