What is 'The Wealth Effect'

The wealth effect is a theory suggesting that when the value of equity portfolios are on the rise because of accelerating stock prices, individuals feel more comfortable and confident about their wealth, which will cause them to spend more. In 1968, for instance, economists were mystified when a 10 percent tax hike failed to put the brakes on consumer spending. Later, the sustained spending was credited to the wealth effect. Even though disposable income declined because of the additional tax burden, wealth continued to grow because the stock market persistently climbed higher.

BREAKING DOWN 'The Wealth Effect'

The wealth effect can benefit economic growth during bull markets for stocks. Sizable increases in investment portfolios tend to make people feel more secure about their wealth and their level of spending. However, this relationship is a double-edged sword, as weak equity performance in bear markets erodes economic confidence.

The wealth effect reflects the psychological effect that rising asset values, such as those that occur during a bull market, have on consumer spending behavior. The concept hones in on how the feelings of security, referred to as consumer confidence, are strengthened by the rising value of assets. In turn, this confidence contributes to higher levels of spending, but lower levels of saving. This phenomenon has been known to occur regardless of changes in discretionary income, in both a positive or negative direction.

In addition to its relationship to personal spending, this theory can also be applied to businesses, as companies tend to increase their hiring levels and capital expenditures amid rising asset values, in similar fashion to that observed on the consumer side.

Rising Portfolio Value and Disposable Income

A gain in the value of an investor’s portfolio does not actually equate to higher disposable income. Initially, stock market gains must be considered unrealized, as they are still tied to the investments, which is not the same as increases in regular income. An unrealized gain is a profit that exists on paper, but that has yet to be sold in return for cash.

Validity of the Wealth Effect Theory

There is considerable debate among market pundits about whether or not the wealth effect truly exists, especially within the context of the stock market. Some believe the effect has more to do with correlation and not causation, proposing that increased spending leads to asset appreciation, not the other way around.

While it has yet to be definitively connected, there is more robust evidence which links increased spending to higher home values. Proponents of this theory point out that increased consumer spending can be stimulated by lower interest rates and easier access to credit, especially in segments of the economy like the housing market. Lower interest rates often lead to a greater number of home sales, which in turn results in higher home values as demand outweighs supply.

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