The wealth effect occurs when you perceive yourself to be getting richer and increase your household spending. This perception does not necessarily correlate with the reality of your spendable income, which may not have increased accordingly. Here’s what you need to know to keep your finances secure.
A financial advisor can help you create a financial plan that aligns with your long-term goals.
What Is the Wealth Effect?
As explained by the National Bureau of Economic Research (NBER), “the ‘wealth effect’ is the notion that when households become richer as a result of a rise in asset values, such as corporate stock prices or home values, they spend more and stimulate the broader economy.”
In other words, households perceive themselves as wealthier because their major assets have gained value. They then increase spending according to this perceived financial status. However, there is no increase in cash flow or spendable income. So, households aren’t making more money, but they spend more anyway – they just feel richer because of unrealized gains in major assets.
The wealth effect isn’t entirely irrational. Often it can reflect anticipated realization. A household might intend to sell the newly-valuable underlying assets, so they begin spending in anticipation of those future gains.
For example, if you’re planning on selling your house in the next few months, and the property value has increased, then you might start spending money that you plan to soon have. Or asset prices might give a household greater confidence in their financial situation, since they have a more valuable basket of assets to tap into at need.
This spending can also reflect a general improvement in economic conditions, as the wealth effect has a known macroeconomic impact. Typically, the wealth effect will reflect a systematic or economic shock (rising stock market or property values, for example), so a broad cross-section of households will increase their spending. This, as cited by the NBER’s working paper, tends to be associated with employment and payroll growth, making the local economy more prosperous and causing individual households to adjust their planning accordingly. As the Boston Federal Reserve wrote on the subject, “it may be the case that consumption is responding primarily to revisions to households’ expectations about future wage growth.”
But the same employment gains also tend to highlight the dark side of the wealth effect.
The Problems With the Wealth Effect
While the wealth effect can be good for a local economy, it’s generally not good for individuals and households. In fact, the Federal Reserve finds that it often makes households net-poorer despite their rise in overall asset values.
To see why, let’s take another look at the NBER data.
While employment and wages tend to go up as local wealth increases, this effect narrows under closer inspection. The wealth effect primarily boosts jobs in food service, retail and home construction. In other words, when households are feeling flush due to the wealth effect, they tend to eat out more often, spend more on shopping trips, and buy newer or bigger homes.
Buying a new home might be a good use of funds depending on the circumstances, but restaurants and retail aren’t. This isn’t to say those are bad sectors, they just don’t create value. When a household puts money into a dinner out or consumer electronics, this is pure consumption rather than any kind of investment or driver of long-term growth.
This isn’t a problem for households spending cash on hand. However, the wealth effect occurs when consumers feel wealthier without an increase in disposable income, which creates a financial bottleneck. Since restaurants and retail stores don’t take payment in credit against housing value, shoppers require a source to support increased spending. Without an increase in liquid income, that cash typically comes from one of three sources: savings, debt, or assets:
- Savings and debt: Spending down savings and taking on new debt both make a household poorer. By depreciating savings through consumption, a household reduces its cash reserves, but doesn’t gain anything from a net asset perspective. The same is true to an even greater degree with debt. In that case, typically funded with credit cards, a household must pay both the value of the spending and the value of any ongoing interest.
- Assets: Selling assets can have more complicated long-term effects. Some are illiquid, like real estate and housing, while others are more liquid, like securities.
- Housing: Real estate generally isn’t sold in small parcels to raise cash, and a home is more of a nondiscretionary consumable than a marketable investment. Nonetheless, the wealth effect tracks strongly to local housing prices, indicating that households tend to significantly increase their spending based on the value of an asset they cannot effectively monetize, leading them to depend on savings and debt as sources of cash.
- Liquid securities: While liquid securities are easier to monetize, selling them off eliminates a household’s long-term ability to save and build wealth. This can fuel a magnified version of the dynamic found in spending down savings. When a household liquidates investment assets to pay for a rise in shopping and spending, this tends to make them poorer by exchanging long-term growth for short-term spending.
- Non-liquid securities: The wealth effect tends to correlate just as strongly with non-liquid securities like retirement accounts and pensions. In those cases, households feel and spend wealthier because they see accounts like a 401(k) increase in value. But unless they’re retired, households can’t convert those assets into cash. As with housing, they have to generate cash for their new spending primarily through savings and debt, again leaving them poorer.
How to Avoid the Wealth Effect
The best way to avoid the wealth effect is with a personal budget.
As the Corporate Finance Institute puts it, “the true danger surrounding the wealth effect is the misguided impression that an individual or household is wealthier simply because a bull market’s sent stock [or housing] prices soaring.” But in the same warning, you can also see the solution: it is an impression of wealth.
The wealth effect is an emotional response to generalized information. As a consumer, you feel wealthier because the market has gone up. This doesn’t mean that you actually are wealthier, because you haven’t converted that value into cash flow yet.
So don’t spend a penny until you do.
Have a good personal budget for managing your finances. Know how much money you have coming in each month and how much money there is going out. This is a habit that every household should have. You don’t need to track your money to the last dollar, but you should have a pretty clear impression of what you have, need, want and spend.
Then, you don’t need to do anything to avoid the wealth effect. Stick to your budget and you’ll see that your “have” column hasn’t actually increased. Without new income or liquidating assets, you have the same amount of cash coming in the door that you did before. Without new income, you won’t have room in your budget for new spending. You’ll be managing your money by the actual numbers instead of by a feeling, and that will make all the difference in the world.
Bottom Line
The wealth effect is when households feel richer because assets like stocks and homes have increased in value and, as a result, they begin to spend more money without a corresponding increase in consumable income. While this can be a good thing for a local economy, it’s very dangerous for your personal finances.
Tips on Making a Household Budget
- Budgeting can be overwhelming. The idea of actually tracking your spending every day, from the rent check down to a cup of coffee, seems exhausting. But the good news is, it really doesn’t have to be. Try these six simple steps, and you’ll have a household budget you can rely on.
- A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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