The False Perceptions Of The Wealth Effect

The next Financial Psych-out is not as pervasive as the “proxy money” effect, but still impacts most of us at some point in our lives. (I have met folks that have gone through this process several times.) It is called the “Wealth Effect”.

The Wealth Effect
“Asset Bubbles” form when the short-term demand for a given asset outstrips the supply. Eventually the market for nay given asset will stabilize, either by a drop in demand, an increase in supply, or some combination of the two. The problem is that the sudden increase in some asset’s value creates the impression that it will continue (temporal proximity bias – a topic for another day), so folks want to get in on the “action” creating even more demand and pushing prices higher. At some point there is a trigger event and people’s impressions change. Usually this creates a drop in demand, which puts downward pressure on the price, and the whole thing reverses rather dramatically. In the last twenty years we have seen this cycle in stocks, oil, and real estate. The real estate bubble was particularly impactful because so many people own homes. We are seeing a similar pattern in treasuries and gold now. Sorry if I am insulting your favorite metal (and maybe this time is different) but if it looks, feels, and smells like a bubble I will treat it like a bubble.

The bubble burst has a pretty dramatic impact on its own, but the impact of the “POP” would be much easier to take if it was not for the “Wealth Effect”. The wealth effect is a form of “equity-itis”, a misperception of our wealth based upon the equity we have in value-inflated assets. We begin to think of ourselves as wealthy because we own something that has increased in value dramatically and our increased net worth leads us to spend in line with our new-found wealth. I know what it feels like. My home tripled in value over a decade, and then promptly dropped 50% from the high. Bummer.

Imagine that you have a steady, disciplined, financial life. Your spending is in line with your net worth and you save a bit each month. Then someone walks up to you and hands you a closed box. Somehow they convince you that the box has a million dollars in it, that it is your money, and that you can tap into the money anytime you want. You go home feeling much wealthier. How would that affect your life? Would you expand your lifestyle? Would you buy a new home, a better car, or take a dream vacation? When you come back from your month in the Caribbean, you drive your new BMW to your new mini mansion and get ready to pay the bills. So far all is good, but when you open the box it only holds a half million dollars, or a quarter, or maybe nothing at all. Suddenly you are in trouble. You have to sell the house, give up the car, and are cutting back on everything to pay off the card you booked the cruise on. It is bad enough when it happens to you, but when it is happening to most of your neighbors as well: it is called a recession.

This financial psych-out is an easy one to fall into, especially when everyone around you is doing the same thing. The thing is to learn from the pain of others (or your own pain) and manage credit with the caution it deserves. Just because your house or your portfolio is big today, don’t assume it will be tomorrow.

In the next entry of this series of Financial Psych-outs, we’ll take a look at “Financial Inertia.” Stay tuned!

About the author

Jim Heitman, CFP®

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