What is the "Wealth Effect?"
Many people spend more money when they feel their 401k (or any other retirement plan they have) or house value is up.
The Wealth Effect is hotly debated. Intuitively though, if you feel like you have more money, you do tend to spend more. Here’s the problem. There is a big difference between feeling that you have extra money … and having extra money.
Just because your house value is up now, doesn’t mean it will stay up. And you are not spending money from the house; you are spending money from your budget. It is the same with your retirement plan (401k, IRA, Roth, etc). They may be up now … but that balance doesn’t always stay up. And again, you are spending that money out of your current budget, assuming you are not retired yet. Even retired, people tend to spend more when they feel flush with money, regardless of the source of that feeling.
Many of my blogs talk about how you should be prudent with your money throughout life. There are ways to measure how much you should prudently spend at any phase in your life.
It may seem unusual to talk about Wealth Effect if the markets are down. But, the opposite tends to happen – when you don’t feel like you have “extra,” you tend not to spend. The effect works both ways.
Moral of the story: What is really happening are mind tricks which influence your behavior with your money. Understand what you are seeing and feeling – and you are a lot closer to prudently managing your money.
More on Wealth Effect for those who want to dig deeper: