As you enter your apartment, you unlock your phone again to find the app still showing the discount on the latest model of your 18-month-old phone. Without much thought, you click ‘Buy Now.’
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What’s at play here is the “wealth effect,” a concept that describes how an increase in perceived wealth—whether from rising home values or a surging stock portfolio—encourages more spending, even when actual income remains unchanged.
First explored in a 2001 paper by Karl Case, John Quigley, and Robert Shiller, the wealth effect was revisited in 2013, showing that housing wealth significantly influences household consumption. A recent Visa study in the US found that for every dollar increase in household wealth, spending rose by $0.34—$0.24 from securities and $0.20 from housing.
The reverse holds true as well: a decline in perceived wealth often leads to more cautious spending.
The mental trap
The wealth effect isn’t based on actual cash but is a psychological shift, much like the feeling of walking on a thick carpet that feels softer than a bare floor. It creates a cushion of comfort that encourages spending, even if that cushion is illusory.
Human psychology plays a central role here. We prioritize short-term changes over long-term planning and fall into mental traps like “mental accounting,” where we treat money differently based on its source. For example, people tend to spend tax refunds more freely than salary income.
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This trap often leads to decisions that feel satisfying in the short term but can harm long-term financial health:
- Upgrading cars prematurely, where the excitement fades but higher loan payments remain.
- Purchasing luxury gadgets that are used infrequently and collect dust.
- Undertaking costly renovations that add little financial or emotional value.
- Overreacting to market downturns by cutting back on vacations or health insurance.
- Delaying necessary repairs, leading to higher costs in the future.
The enduring lesson from market history
To guard against the wealth effect, it’s crucial to remember that long-term market returns tend to revert to the mean.
After significant market rallies in 2003, 2014, and 2017, subsequent returns were muted. On the other hand, markets often see more substantial returns following downturns, such as in 2000, 2008, and 2011. The range of returns for any ten-year period is far narrower than the volatility of any given year.
The takeaway here? Resist the urge to base financial decisions on short-term fluctuations in wealth, whether it’s splurging when your portfolio is up or feeling despondent when it dips.
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Adopting a “never too high, never too low” mindset can help you stay focused on your long-term financial goals, regardless of recent market movements.
Strategies to stay grounded
How can we harness the psychological benefits of rising wealth without letting it lead us into poor financial decisions?
Automate finances to reduce decision fatigue: Every financial decision, whether big or small, drains our limited mental energy. Automating savings, bill payments, and investment contributions reduces the mental burden and ensures that your financial plan stays on track.
Cooling-off period for big purchases: Implement a cooling-off period—say, one week—for any unplanned purchase over a certain threshold. This provides the time to step back, reflect on whether the purchase aligns with your long-term goals, and make a more thoughtful decision.
Frame wealth in terms of life goals: Instead of viewing wealth as a static number, frame it in terms of life goals, like months of living expenses, percentage of your child’s education costs, or your financial independence target. This perspective helps clarify what’s truly important.
Celebrate with lasting, productive upgrades: Rather than unnecessary indulgences, use newfound wealth to invest in meaningful, long-term improvements—such as upgrading your workspace or investing in health-focused services or memberships.
Do something meaningful for your loved ones: Consider using your wealth to enhance the lives of those around you—such as gifting new parents a year of full-time help, sponsoring a family member’s education, or creating lasting family memories.
Create a vision fund: Set aside funds for aspirations like starting a business, taking a sabbatical to write a book, or learning a new skill. Avoid aimless spending by focusing on investments in your future.
Lifestyle upgrades naturally come with growing wealth, but it’s important to prioritize enhancements that bring lasting value, whether through health, education, or meaningful experiences. Conversely, the reverse wealth effect—a decline in perceived wealth—can trigger unnecessary austerity or poor financial decisions motivated by fear.
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While powerful, the wealth effect can be managed with intentional strategies, turning it from a potential pitfall into a tool for building a more fulfilling financial future.
Anoop Vijaykumar, Investments and Head of Research at Capitalmind.