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The economy is in a rough place right now, and everyone is feeling it. And yet, social media would have you believe otherwise.
Don’t believe me? Open any app right now and see what’s being posted. Maybe a gorgeous view from a ski resort, complete with a designer label scarf hanging on the chaise. Or you spy a casual cafe haunt, a cup of coffee on the dashboard of a luxury car.
But you know that person has just been doing the same job they always have been. So, did they strike it rich overnight or sell off a huge asset?
Well, yes and no. Welcome to the bizarre world of the wealth effect, where people feel the need to live the high life when their actual financial status hasn’t changed all that much, solely because things around them are going up in value.
Explaining the wealth effect as a physician is hard but it is more prevalent in the medical fraternity than you’d think. So today, let’s discuss the wealth effect, how it manifests and why it’s become such a hot topic recently:
- Where does the wealth effect come from?
- Is it healthy to be under the wealth effect?
- Could the wealth effect actually help the economy?
The Wealth Effect: Rise In Assets, Rise In Spending?
The wealth effect is a behavioral phenomenon where people start spending more money as the value of their assets rise, despite it not directly raising income.
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Based on economics, the wealth effect examines how an individual is more relaxed about their financial security, just because things they own increase in monetary value, like real estate. But that doesn’t mean that that increase in value is their actual income growing.
See, assets like real estate or investment portfolios are known as non-liquid assets, meaning they’ll take time before they convert into cash. What we count as liquid assets is readily available money, in the form of a fixed income and savings.
Basically, the wealth effect shows that people feel more confident in their finances when those non-liquid assets increase in value, even if their salaries and fixed costs remain the same as before. And so, their spending increasing reflects that changed perception of wealth.
A clear distinction that needs to be made when discussing the wealth effect is that it isn’t about spending what you don’t have. Obviously, if you know you have the money somewhere, you’ll be more inclined to splurge on a nice trip. It’s simply about security.
The wealth effect is a psychological one, one that directly correlates with consumerism in the market.
People simply spend more when they feel like they are richer. Like, an overworked resident going for a nice espresso from a cafe instead of sticking to the freeze dried stuff available at the hospital cafeteria for cheaper, just because the stock they bought in 2009 went up in value.
How Does It Work?
So, you often see the wealth effect occur during what’s called a Bull Market – an economic environment where prices for financial securities start rising. Think things like real estate, investments such as stocks or even gold and currencies, but the threshold is generally agreed to be a 20% increase.
When this is happening, consumers can be observed as spending their money more freely for commodities. Because their assets rise in value, they feel more secure about their spending, known commonly as consumer confidence.
And so, people continued to buy things that, in hindsight, they couldn’t budget in before. Fast food gets traded for a nice steak dinner, a date night out in the city becomes a weekend in the Hamptons.
We saw an example of the bull market back in the 1960s, aka the ‘Go-Go’ years. Despite a 10% hike in taxes, people continued to splurge on more high end goods. Why? Because the stock markets were rising so steadily, they didn’t have to worry about going bankrupt.
But in the end, that kind of financial security is only on paper. It isn’t something that can be used instantly to purchase an expensive lifestyle.
A rise in your investments and assets value does not equate to a higher disposable income.
Think of the wealth effect as people using their investments during a bull market as a sort of piggy bank. Whenever they need the money, they have it, even if it can’t be liquidated on the spot.
How Does That Affect Us?
If you were a physician prior to the Housing Market Crash of 2008, you might’ve tried cutting your losses and selling what real estate you had to have a nest egg for future retirement. Because Lord knows, the Credit Crash spared no one.
But then, in 2009, you might’ve bought more assets instead, like stocks. And those have only grown in their investment potential over the past decade. So congratulations, your investments actually paid out!
But that doesn’t mean you can spend like a high baller. If investment opportunities have gone up in value, so has inflation.
Consumerism is at an all time high and everyone wants to be part of it. But the cost of hyperconsumerism is that we are left with less money to put away for a rainy day. And trust me, if the economy keeps going like it is, there will be a monsoon.
It’s why you need to be smart about your money and how you’re investing it.
We talked about bull markets, but the opposite also happens. A bear market is when investments start dropping in value, usually indicating a weakening economy. Companies start liquidating assets, laying off employees en masse. Investors don’t want to be risk-taking, but risk-averse instead.
Which is what we should be as well. Despite how much it looks like we’re in a bear market on social media, we are very much in a bull market post 2022. Bear markets usually follow after events such as geopolitical issues, burst economic bubbles, and pandemics which, well, we’ve been through at least two of those in the last 5 years.
Tackling The Wealth Effect
While it is rewarding when your gamble pays off, now isn’t the time to be spending needlessly. The wealth effect makes you believe you have more than you think, but the opposite can also happen. So, what should we, as doctors, be doing with our money and assets right now?
Changing your investment plans to suit your needs is better than timing the market. Instead of allocating all your assets into investing in one place, make some safe bets by keeping most of it in savings. If you don’t want to risk it, then don’t. In the end, you’ll still have money to fall back on.
But that doesn’t mean stop diversifying your investment portfolio entirely. You might lose some money here and there, but ultimately you’ll still have more than you started out with. Just do it without compromising on your long term investment plans.
A solid investment plan – in writing – will help you stay on the path when your bank account reflects good figures. And if you’re like me where you went to med school precisely because you wanted to avoid numbers of any kind? Hire a financial planner that can do the guesswork for you.
Cover all your bases, from mortgages, student loan debt and more. Don’t buy a big house that you can’t manage the expenses for, plan for exactly what you need. The less you have to give out, the more you get to keep and build on top off, after all. And that leads to great retirement savings too!
Final Thoughts
Really, the key is to be smart with your money without letting outside influence get in the way. This is what the wealth effect can end up doing; it makes you think you have more than you can spare.
Combatting that is just a matter of being resolute with your morals and not getting swayed by what you see online.
