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What is the Wealth Effect?

Posted By Jim On 04/21/2010 @ 7:15 am In Personal Finance | 17 Comments

Have 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?

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