Understanding the Wealth Effect: How Rising Asset Values Impact Spending

The wealth effect is a theory centered around the idea that when equity portfolios are consistently earning, the owners feel secure in their wealth and are more likely to spend. Rising equity portfoliosEquity vs Fixed IncomeEquity vs Fixed Income. Equity and fixed income products are financial instruments that have very important differences every financial analyst should know. Equity investments generally consist of stocks or stock funds, while fixed income securities generally consist of corporate or government bonds. are caused by an accelerated increase in stock prices. The perception of greater wealth leads the individual portfolio holder to spend more frivolously, or at least less cautiously.

The Wealth Effect and Spending

The wealth effect theory posits that, in general, consumers are more likely to spend, and significantly so, when portfolio performances are high. Such situations occur in a bull market, when stock pricesInvesting: A Beginner's GuideCFI's Investing for Beginners guide will teach you the basics of investing and how to get started. Learn about different strategies and techniques for trading are up and portfolios regularly see higher profits.

The wealth effect theory comes with a psychological component. A higher portfolio performance leads portfolio holders – consumers – to see themselves as wealthier individuals. This makes them likely to spend more and more money on non-essential or luxury items.

Real World Impact of the Wealth Effect

So, what does the wealth effect look like in real life? A number of things typically happen when individuals or households see an increase in wealth, followed by the perception of increased disposable income. They include:

• Greater confidence in their ability to spend and being more adventurous with their spending. This includes making riskier investments or taking out risky loans that may pose a problem when the market turns.
• Consumer spending ratesEconomic IndicatorsAn economic indicator is a metric used to assess, measure, and evaluate the overall state of health of the macroeconomy. Economic indicators increase, which exerts a significant and important impact on the economy.

The impact of the wealth effect on consumer spending is significant. Consumer spending, in the United States, is one of the largest and most important drivers of the nation’s economy. The wealth effect can create a potentially dangerous scenario for the entire economy, as follows:

• Consumers caught up in the wealth effect begin spending more freely.
• The higher spending gives rise to both increased production to meet consumer demand and rising inflation ratesInflationInflation is an economic concept that refers to increases in the price level of goods over a set period of time. The rise in the price level signifies that the currency in a given economy loses purchasing power (i.e., less can be bought with the same amount of money)..
• A market correction suddenly causes financial problems for overextended consumers, who are forced to quickly rein in their spending and/or liquidate investments.
• The marketplace experiences an oversupply because of the increased production that is now no longer being met by high consumer demand.

Being Cautious of the Wealth Effect Trap

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 prices soaring. Strong equity portfolios are, of course, a great thing, but their value can change rather quickly.

It’s wise to preserve and bolster wealth, especially during wealth effect periods and to hedge against the bear market that is inevitably going to follow any bull market. It’s perfectly acceptable to spend more if there is additional money to be spent. However, it’s not wise to overextend oneself financially or become much more speculative with investments.

One good way to preserve and create wealth is to work with the trend, not against it. Contrarian positions pay off – sometimes – but it’s typically wisest to work with the market, bull or bear, when making any investments or trading plays.

Final Word

The wealth effect is a theory with a psychological component that leads to real-life outcomes. Individuals and households experiencing a wealth effect perceive themselves as wealthier and are thus prone to spending more. This leads to changes in consumer spending rates that actively affect the domestic economy.

Additional Resources

Thank you for reading CFI’s explanation of the wealth effect. CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

• ConsumptionConsumptionConsumption is defined as the use of goods and services by a household. It is a component in the calculation of the Gross Domestic Product
• Bullish and BearishBullish and BearishProfessionals in corporate finance regularly refer to markets as being bullish and bearish based on positive or negative price movements.  A bear market is typically considered to exist when there has been a price decline of 20% or more from the peak, and a bull market is considered to be a 20% recovery from a market bottom.
• Marginal Propensity to ConsumeMarginal Propensity to ConsumeThe Marginal Propensity to Consume (MPC) refers to how sensitive consumption in a given economy is to unitized changes in income levels. MPC
• Personal FinancePersonal FinancePersonal finance is the process of planning and managing personal financial activities such as income generation, spending, saving, investing, and protection. The process of managing one’s personal finances can be summarized in a budget or financial plan.