Is the Wealth Effect Making You Think You’re Rich?

“How are you feeling?”

As a physician, that phrase, or something close to it, may have been one of the first questions you ask of a patient.

It works in finance, too. Much of the economy is driven by consumers’ confidence in their current situation and their outlook for the future. And you can certainly have a rosier assessment of your financial position than the numbers would actually bear out.

But is there actual wealth behind that feeling of “being rich?”

This Saturday Selection was originally published on the White Coat Investor.

 

 

A famous football coach once said, “You’re never as good as you think you are when you win, and you’re never as bad as you feel when you lose.” Investors should modify that quote just a little bit to help them maintain perspective and stay the course with their investing plan.

 

You’re Not as Rich (or Poor) as You Think You Are, and That’s OK

 

It is the natural tendency of an investor to assume that their account balances are what they really own. Aside from the fact that the government owns some as-yet-unclear portion of your tax-deferred accounts, this is a very misleading attitude that leads to poor financial decisions. The “wealth effect” is well-known.

 

What Is the Wealth Effect?

 

The Wealth Effect refers to the fact that people spend more when their assets increase in value, such as a run-up in stocks and real estate prices. The Wealth Effect changes an individual’s perception of wealth—they feel richer, even though their income and fixed costs have not changed.

At its worst, people use their home equity as ATMs, pulling it out to spend it on consumer items. While you would think the wealth effect is a behavioral error that you should work hard to avoid, it isn’t all bad. At market highs, future expected returns are lower, so maybe that should tilt the spending vs. saving balance a little bit.

 

Bull Markets and the Wealth Effect

 

Assuming a long-term investment horizon, the reality is that at near bull market tops, you have lower expected future returns and lower yields from your portfolio. Yes, you have more money in the account, but the money is actually worth less than it used to be! Don’t spend too much time congratulating yourself on your investment acumen and counting your wealth. A good percentage of it, perhaps even half of the money you have invested in risky assets, is almost surely going to disappear temporarily at some point in the next five years.

An even worse tendency on the bull market side is the idea that your account balances have gone up dramatically in the last few years because you’re a brilliant investor.

As John F. Kennedy said (admittedly in a different context), a rising tide lifts all boats. From 2009 until the beginning of 2022, you could have bought just about any asset and done great. By April 2021, over the previous decade, US stocks were up 264%, international stocks were up 66%, large growth stocks were up 352%, small value stocks were up 250%, and REITs were up 135%. Bonds were doing fine too with TIPS up 38% and nominal bonds up 53%.

Even precious metals had positive returns over that decade. Housing prices went up dramatically as well over the last decade.

Meanwhile, inflation, though it rose dramatically in the first half of 2022, had been very low at 1.7% per year for the previous 10 years, so the vast majority of those exceptional returns were real, after-inflation returns, at least in the way CPI is calculated.

 

Should You Cut Your Losses and Sell Out at Market Lows?

 

Lots of investors, including many physicians I know, sold out at the market lows of 2008-2009. They looked at their recent losses and compared their balances to how much they used to have and how much they needed in retirement and decided they could not afford to lose anymore.

Perhaps if they remembered that they really didn’t have as much as they thought they had in early 2008 or as little as they thought they had in March 2009, they would not have done so.

 

Should You Try to Time the Market?

 

the wealth effect

Playing around on the edges

I’m not advocating that you somehow try to time the market. Remember, a bear market is a semi-regular occurrence. You will lose some money in bonds. You will lose some money in stocks. You will lose some money in real estate. You will lose some money in precious metals. The only reason to change your asset allocation (investment plan) is in response to changes in your need, ability, and desire to take risk.

I think it is OK to play around on the edges, perhaps a 5% variation in your stock-to-bond ratio, perhaps putting a little more money into paying down debt and a little less into your investment portfolio, perhaps rebalancing a little more often, etc.. But realize that these little moves are probably just as likely to cause you to lose money as to gain it.

Don’t believe me? Write down the little changes you make and the reasons you made them and go back in a year or two and see how clear your crystal ball was. It might satisfy an urge to tinker. Better to make little mistakes than big ones.

The reason that market timing is so difficult is that not only do you have to figure out what will happen in the future, but you also have to time two events at least relatively successfully—an exit and an entrance. This is surprisingly hard, even for an unemotional Spock, but add in some of the emotional effects caused by greed and fear, and it is nearly impossible. As John Bogle said about market timing,

“After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know of anybody who knows anybody who has done it successfully and consistently.”

 

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How to Combat the Wealth Effect

 

So, what should the investor do to combat the wealth effect? The same thing they always need to do. Stay the course. If you’re still a decade or more away from retirement, just stick to your written investing plan. Keep your 60% (or whatever) stocks in bull markets and in bear markets. Don’t get greedy and abandon bonds, especially out of an irrational fear of some bond bear market. Do not start spending more or buy a bigger house because your balances seem large. Remember that a significant chunk of your investment account isn’t really there.

What? You don’t have a written investing plan in place? Well, go get that first. Consider taking my online course (cheaper but more work required) or hiring a good financial planner (more expensive but less work required) so you know exactly what to do with your money.

If you are very near retirement (at the point where a bear market in the next five years would cause you to have to work longer), take a look at your need to take risk. Perhaps you no longer need 8% returns to meet your goals. If you no longer have a big need to take risk, perhaps this is one of those times to dial back the risk in your portfolio a bit.

At market highs, consider paying off your mortgage and student loans with new savings. Those returns are guaranteed no matter what the stock and bond markets do. Maybe also step up your giving and donate appreciated shares to charity; even if the market goes down later you will still get the full tax deduction, and in the meantime, your money can do some good in the world.



 

What do you think? What have you done to combat the wealth effect in bull markets and in bear markets? Comment below!

 

2 thoughts on “Is the Wealth Effect Making You Think You’re Rich?”

  1. This is so easy to write and so hard to do.

    I managed to stick to the plan until I had “lost” on paper 500k a few months ago, and with it my ability to retire in a year as I had planned. At that point I sold half my investments, putting me in the strange position of feeling bad when the market goes up( which it did) and bad when it goes down( because I still lose money in the invested half). In other words I’m miserable either way.

    I think in the very early years it’s easy to make up a 20 percent decline with a paycheck. But if you worked 30 years, then 20 percent down is 6 years of savings (and gains) down, and that is emotionally quite different.

    I failed at my task in the end. The size of the losses spooked me. I tell people playing blackjack, you’ve got to hit 16 into a dealers face card, painful though it is.

    I stood😔.

    Reply
    • Shoot, that’s tough.

      Back in 2020, I lost a million on paper for the first time. I Know it will happen again, probably more than a few times over my lifetime. Having written about the likelihood of a big loss and contemplating that inevitability ahead of time made it easier to stomach. You have to accept that volatility isn’t going away, and if you want to benefit from the ups, you’ve got to ride out the downs.

      Best,
      -PoF

      Reply

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