The Wealth Effect
One of the great rewards of disciplined long-term investing is the satisfaction of watching your nest egg grow. While steady growth is expected with steady contributions, market volatility can shrink and expand that account balance in ways which can trigger fear, greed, and a host of other emotions.
Since we're investing for the long-term, experts tell us to ignore these emotions and, to a large extent, avoid looking at the account balance in the first place. But alas, investors are human. As humans, we feel doubt when our account balances shrink and, conversely, feel content - even somewhat smug - when they swell during a bull market. Our investing discipline and judgement are awarded the credit for the windfall, instead of simply noting that "a rising tide lifts all boats". Economists note that during these prolonged market runs we also tend to "feel wealthy".
This feeling of wealth has its roots in the confusion between amassed, static, long-term wealth and monthly cash flow. When we look at a investment account statement with five or more digits to the left of the decimal, thoughts can enter our head. Thoughts like "Wow, I could buy a car with cash!" or "OMG, I could buy a house with cash!". While one rarely attempts to liquidate their long-term saving in exchange for these items, an investor who rides the market to a "car-cash" or "house-cash" balance can be more confident in their financial footing. That's a good thing. But a run-up in investment account balance has no effect on one's monthly cash flow.
However, sometimes that confidence borne from high investment account value may lead to a loosening of day-to-day budgeting discipline and a notion that splurging is OK since "my investments are doing so well". Harkening pack to the concepts section, as your pool fills, it can feel like you income stream has increased, even though it hasn't. So ask yourself this:
Assuming a constant current paycheck, would you be more likely to buy a new automobile if your long-term investment value were to double?
If you answered no, good. But if you answered yes, you may be susceptible to the wealth effect.
The wealth effect can benefit the economy as a whole, since increased consumer consumption drives corporate revenue which helps drive stock price. Increased stock prices in turn lift mutual funds which life individual account balances. So, in the aggregate, the wealth effect can actually help build wealth. At the personal level however, it's important to realize that market fluctuations - even those which grow long-term account balances - should not be used to make budgeting decisions. Those long-term accounts are growing money to enable future consumption and are best considered separately from the income cash flow (paycheck, rental income, etc.) which enables current consumption.
Wealth effect can also be triggered by strong housing market. The good news is the best way to fight the wealth effects' impact on your financial life is simply learning how swelling account balances can sway your judgement. Learn more by clicking the link below.