When the market's up and your investments are in great shape, you just feel a little better. According to behavioral economists, this can cascade into the wealth effect on a grander scale. Read on to learn about this effect, what it is, what it isn't, and how it can affect you as an investor.
Overview
What is the wealth effect?
The wealth effect is a phenomenon recognized by behavioral economists that describes an increase in spending behaviors when people and businesses feel like they're doing better financially. This is often in response to a rapidly growing economy, where the value of their assets is climbing rapidly.
For example, if you bought your house in 2019 and you still lived there in 2023, your rapid increase in home equity could have caused you to feel much wealthier, despite not actually making more money. You might have then booked more expensive vacations, eaten out more, or just generally been less careful with money.
Housing vs. stock market
Housing versus stock market wealth effect
Although the wealth effect is generally tied to an increase in many assets, some economists are taking a deeper look at how it actually works. Some believe that the wealth effect is significantly stronger when housing values increase, rather than when stock prices rise.
This could be because housing values tend to go up and stay up long term, and it's rare that home values decrease significantly. Stock prices, however, can rise and fall regularly in a healthy market. However, if stock prices go up and stay up, that could possibly have the same effect as a rise in housing values.
Wealth vs. Pigou effect
Wealth effect versus Pigou effect
If the wealth effect explains increases in spending in times of asset appreciation, the Pigou effect is its deflationary cousin. The Pigou effect is about the relationship between deflation, or a systemic drop in asset values, and reflexive consumption.
Instead of buying things because they feel better off than they may really be, under the Pigou effect, consumers who have been hoarding cash eventually spend it when deflation reaches a certain point because they are actually holding significant amounts of valuable cash compared to the wider market, with more buying power.
Both lead to more spending, but for very different reasons.
Related investing topics
Why it matters to investors
Why the wealth effect matters to investors
Investors are wise to pay attention to the wealth effect.
The most important reason, of course, is that they're just as susceptible to it as anyone else. If your portfolio starts to grow rapidly without your adding any positions or doing much of anything, you may start to feel a lot more secure about your financial position in life.
However, you can fall into a trap where you end up borrowing or spending more than you should, effectively decreasing your wealth despite the raw numbers.
The other important reason, of course, is that a wider wealth effect can stimulate the economy, or crash it, depending on what's going on. You want to see more consumer spending if you own companies that rely on consumer spending to thrive, but within reason. If consumer spending goes off the rails, you can expect a drawdown to be on the way, since that simply cannot last forever.
When your stock rises and then falls, you need to decide how far it can fall before you lose faith in it. If the company is still solid, it may be able to ride out a market-wide drop in faith in the stock, but if the company itself fell prey to the wealth effect during its boom times, that's reason to reconsider your relationship with it.
