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What is the Wealth Effect?

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Gold BarsHave you ever heard of the wealth effect? Basically, it’s the idea that you will spend more because you feel richer. You feel richer because you think home prices are up or because your stock portfolio has increased in value. Economists like to talk about the wealth effect whenever they look at consumer confidence and consumer spending numbers, because those are economic figures. It’s a term that really becomes very popular when the stock market goes up, as it has in recent months. People see their portfolios, with all that unrealized gain, and feel richer. It was a popular topic in the dot com boom and the subsequent housing boom. You see home prices go up and you feel richer.

The problem is that you aren’t actually richer. Unrealized stock market gains are unrealized. Home equity is imaginary value stored in the walls of your home. The wealth effect may give you the confidence to spend more but it doesn’t give you the money to spend more. Your gains are still locked in their investments but you’re spending money like you’ve actually locked in those gains.

The net effect? You are more likely to borrow more on credit because you feel like you can pay it back with the money you’ve “earned.” The wealth isn’t tangible and, more importantly, can evaporate just as easily as it appeared. Home values can fall, stock markets can sink, but that credit card and home equity line of credit debt… those things stick around and demand payment each month.

The easiest way to avoid the wealth effect is to ignore the hype. While it’s great to see your stock portfolio jump in value, remember that you haven’t actually pocketed any extra money. If it’s a retirement account, remember that you can’t cash it in until you retire. It’s OK to get excited but don’t do anything that increases your financial burden.

Do you believe in the wealth effect? How do you counter it? How do you take advantage of it?

(Photo: bullionvault)

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17 Responses to “What is the Wealth Effect?”

  1. Frugal says:

    Refering to the home values, I was told that the market owns the increase in the value, not the homeowner. So true. The homeowner gets the increase upon selling only.

    If we spend the money we don’t own, we are to be blamed.

  2. zapeta says:

    I think the wealth effect exists. People don’t seem to realize that their gains and losses are only on paper until they sell the asset.

  3. Shirley says:

    Yes, I do believe in the wealth effect. I know that I feel much more comfortable and secure when my IRA is on the upward swing rather than losing ground. I would imagine that everyone feels that way. ;-)

    I counter it by not doing anything different than I have always done. That in itself is taking advantage of it because I’m not spending it, even though I actually do feel that I could. It’s a good thing for me (in this situation anyway) that ‘old habits die hard’.

  4. @Frugal – Very, very true and the same could be said of any asset that consumers hold experiencing robust returns.

    @Jim – I’m glad you covered this topic, as it’s something that is partially to blame for our recent series of asset bubbles and massive run of leveraging ourselves to the max. To counteract this effect, you can simply ignore it, or recognize it and act against it (like a contrarian in the stock market). Either way, it’s definitely important to know when it’s happening. Fortunately or not, I think we’ve bubbled ourselves out for awhile.

  5. cubiclegeoff says:

    I think by making sure that you automatically put money into retirement and/or savings, you at least keep building those accounts. Then making sure you only spend what you can afford, you can avoid buying more just because you feel like you’re wealthy. I feel more comfortable spending more when my savings accounts are larger, but at least that money is accessible. I never think of retirement or my home as being of value, because it won’t really be for a significant amount of time.

    I guess, also, if you just check your retirement accounts once a quarter or less, you will be unlikely to think of them as being part of your wealth that is accessible.

  6. blur says:

    I was just reading about wealth effect and I quote : “The wealth effect, as it is known, shows that every $100 gain in a stock portfolio creates $4 in additional consumer spending. But this wealth effect is even more significant for homes. A recent study found that an increase in owned housing value of $100 will boost spending by $9 – more than twice the impact on spending of stock market wealth effect gains.” – Bailout Nation

    • Jim says:

      From what I’ve read, they haven’t been able to prove a correlation as clearly as Bailout Nation seems to claim.

      • The correlation certainly exists. The only argument at this point is over how much it makes a difference and what other forces can dominate it.

        In studying the money supply, higher levels of wealth always lead to higher levels of consumption compared to lower levels of wealth. However, wealth can often be dominated by other factors including changes in income, interest rates, etc.

        This is a big part of what the wealth effect is based upon and the theory behind it makes sense and the data certain seems to support it. Of course, the disclaimer of ‘correlation does not prove causation’ is always in use when you’re talking economics.

  7. This is why so many people are broke even though they make so lots of money. I avoid this problem by spending fairly consistently every month. Even when I receive raises, I don’t spend that money on more things, but save it.

    • jsbrendog says:

      agreed. however you do have to treat yourself every ocne in awhile. you can’t let your quality of life suffer. also, it is hard to maintain a balance but i do try

  8. govenar says:

    Since stocks are pretty liquid, I think you basically really are richer when the stock market goes up. But you can easily become poorer if you stay invested and the stock market goes back down. I think it’s similar to gambling: if you win $100 in a slot machine, you are richer; if you go back to the casino next week and lose the $100, you’re back to where you started, but you wouldn’t say that the person wasn’t richer when they won the $100.

  9. eric says:

    This happens a lot around me. Friends and family who feel for whatever reason they could buy bigger houses and more cars……then of course the Great Recession hit. Two words: reality sucks.

  10. ebekele says:

    Excellent topic Jim! I was caught up in it myself :)
    I had to take the express to reality…


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