What is the Wealth Effect?
The wealth effect is a theory centered around the idea that when equity portfolios are consistently earning, the owners feel secure in their wealth and are more likely to spend. Rising equity portfolios are caused by an accelerated increase in stock prices. The perception of greater and stronger wealth leads the individual portfolio holder to spend more frivolously, or at least less cautiously.
The Wealth Effect and Spending
The wealth effect theory posits that, in general, consumers are more likely to spend, and significantly so, when portfolio performances are high. Such a situation occurs in a bull market, when stock prices are up, which means that portfolios regularly see higher profits.
The wealth effect theory comes with a psychological component. A higher portfolio performance leads portfolio holders – consumers – to see themselves as wealthier individuals, meaning they are likely to spend more and more money on non-essential or luxury items.
Real World Impact of the Wealth Effect
So, what does the wealth effect look like in real life? A number of things typically happen when individuals or households see an increase in wealth, followed by the perception of increased disposable income. They include:
- Greater confidence in the ability to spend and be more adventurous with their spending. It includes making riskier investments and potentially taking out risky loans that may pose a problem in the future when the market turns.
- Consumer spending rates increase, which exerts a significant and important impact on the economy.
The impact of the wealth effect on consumer spending is significant. Consumer spending, in the United States, is one of the largest and most important drivers of the nation’s economy. The wealth effect can create a potentially dangerous scenario for the entire economy, as follows:
- Consumers caught up in the wealth effect begin spending more freely.
- The higher spending gives rise to both increased production to meet consumer demand and rising inflation rates.
- A market correction suddenly causes financial problems for overextended consumers, who are forced to quickly rein in their spending and/or liquidate investments.
- The marketplace experiences an oversupply because of the increased production that is now no longer being met by high consumer demand.
Being Cautious of the Wealth Effect Trap
The true danger surrounding the wealth effect is the misguided impression that an individual or household is wealthier simply because a bull market’s sent stock prices soaring. Strong equity portfolios are, of course, a great thing, but their value can change rather quickly. It’s important to know what to look for and how to act, regardless of whether a portfolio is doing well or not.
It’s wise to preserve and bolster wealth, especially during wealth effect periods and to hedge against the bear market that is inevitably going to follow any bull market. It’s perfectly acceptable to spend more if there is additional money to be spent. However, it is not wise to overextend oneself financially or become much more speculative in one’s approach to investments.
One good way to preserve and create wealth is to work with the trend, not against it. Contrarian positions pay off – sometimes – but it’s typically wisest to work with the market, bull or bear, when making any investments or trading plays.
The wealth effect is a theory with a psychological component that leads to real-life outcomes. Individuals and households experiencing a wealth effect – due to high-performing portfolios via rising stock prices – perceive themselves as wealthier and are thus prone to spending more. It leads to changes in consumer spending rates that actively affect the domestic economy.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: