Like any 8 year bull market run, people start wondering and worrying. “When might this end? How does this impact the economy and spending behavior?” This economic principle is called the Wealth Effect.
The premise to the wealth effect is–as an individual’s wealth increases (generally through stock market or real estate appreciation), we have more financial confidence and generally start spending more. However, the opposite also holds true–during steep market declines, we tend to hunker down and spend less. During that time we feel uncertain and more conservative about the future. Historically, the wealth effect impacts the wealthier disproportionately (as a greater percentage) because more of their wealth is tied into stocks and real estate.
I am a firm believer of the Wealth Effect. Of course, there are cases both supporting and denying the wealth effect. However, in my almost two decades in the financial service industry, I have personally seen hubris during rapid market upswings–clients buy boats, go on expensive vacations, etc. I’ve also seen people afraid to go out to dinners during recessions. Advisors hate to see this. We believe the objective to any financial plan is to maintain a reasonable lifestyle through all economic environments in order to enjoy life to the fullest. Unfortunately, the wealth effect sometimes prohibits lifestyle pursuits, if not managed appropriately.
Good Financial Planning Counteracts the Wealth Effect
The million-dollar question is: how can proper financial planning prevent us from being over, or under, zealous when it comes to our personal finances? We adhere to the following principles to protect our clients from The Wealth Effect.
- It’s so easy to get caught up in market swings, so keep a level head. It’s human nature to react quickly. Here are some simple tips to stay focused and stick to your financial goals.
- The 24 Hour Rule – My kids play sports, we’re not allowed to contact a coach until 24 hours after an incident. This allows the parent to gain a better perspective on what happened and how they choose to react. Trust me, this concept works, even with financial decisions.
- Identify the Real Concern – Many times we see clients react to media or economic swings because of an underlying concern. It’s a great idea to consider from where the “concern” stems. This helps you make decisions to identify and fix root causes. It keeps you from making decisions based on the wrong information.
- Proper diversification plays a huge role in containing the wealth effect. If your assets are aligned to grow properly during up markets (while still having asset classes that can provide steady income), then in down markets you’ve gone a long way in preventing the wealth effect from ruining your financial goals. It’s a delicate undertaking and I recommend working with a well-versed financial expert.
- The final piece in containing the wealth effect is maintaining a current financial plan and model. Your financial plan is your road map to success. No matter the twists and turns (or market up swings and down swings), your plan helps guide you to the right questions to ask, and changes to consider.
Working with a financial planner isn’t always a panacea for everything finance-related, but when it comes to properly managing your emotional and physical habits as it relates to money a proper partner can make a world of difference.