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?”

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

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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.

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.

What Is the Wealth Effect?

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.

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!

Bull Markets and the Wealth Effect

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