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Market Selloffs and the “Wealth Effect”

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When you feel “wealthy”, do you typically spend more than normal? Sure. It’s a subconscious effect of seeing your net worth grow, at least on paper.

Of course, the opposite mindset takes place when we feel our net worth hasn’t moved much, or worse, has declined. You will start to spend less money and cut back on material purchases, even though you may not realize it. This is called the wealth effect and is defined by the change in spending that aligns with change in (alleged) wealth. Typically, the wealth effect has a positive correlation, in that your spending habits move in the same direction as your wealth.

Given that 2018 was a rocky road for stocks, will we begin to see the wealth affect take place here in the US? What about globally? It doesn’t seem like the major corrections we saw last year (February/March and October-December) are having a major impact on spending habits. However, discretionary spending in other parts of the world (such as China) has been curtailed a bit, giving signs that we may soon see a slowdown in spending.

Some have argued that while most who are already retired have less changes in their investment behavior, at least historically speaking, we are also seeing a more passive approach to saving/investing from those who are simply planning for retirement. Thus, there also seems to be little change in investment behavior from these individuals as well. Many Americans are accepting the idea of investing for the long-term and are approaching market corrections as opportunities to invest more rather than reasons to leave.

Another bias that we should be aware of is the anchoring bias. This occurs when retirement savers tend to suffer from down markets. Most individual investors will latch on to specific data points and use this information to guide future decisions. Thus, a declining stock market is known as a negative anchor. Why does this occur? Because savers typically remember their portfolio value at market peaks, before a decline. Over the near term, they will become fixated on getting their portfolio back to that same value. When this happens (“anchoring” to a negative event) it can cause investors to become more risk-averse than they normally would be and can lead to an under allocation of stocks.

Related: Is Your Mutual Fund Tax Efficient?

But is the stock market the only thing that drives the wealth effect? Absolutely not. In fact, most professionals agree that housing prices actually have a greater impact on our sense of “wealth” and therefore a greater impact on our day-to-day spending routine. According to a study done last summer, it was found that over the long timeframes, consumers increase their consumption by roughly 2.76 cents in response to an additional dollar of housing wealth. Therefore, a $10,000 bump in housing value would lead to about $276 of additional discretionary spending.

So, how can those in saving mode curb the unwanted consequences of the wealth effect? Those with a long-term horizon for investing need to understand these corrections, as mentioned, above, are great opportunities. This is particularly true when investing within a 401(k) plan (remember, contribution limits have gone up for 2019). The concept of monthly contributions is an amazing way to avoid mental lapses. In this form of investing, individuals are earning an average price over time rather than attempting to time the market by buying low and selling high.  This allows savers to navigate the ebb and flow of the stock market without getting caught up in specific events or data points.

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