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MoneyAnoop Vijaykumar
4 min
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19 Jan 2025, 03:50 PM
ISTResist 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. (Image: Pixabay)SummaryAs rising asset prices create a sense of financial well-being, many fall prey to the psychological trap of over-spending. But by adopting strategies to stay grounded, we can harness the wealth effect without letting it derail long-term financial health.
You’re standing in the elevator lobby of your 14th-floor apartment, scrolling through e-commerce deals on your phone, though you have no intention of making a purchase. A neighbour enters, and after the usual pleasantries, mentions the price at which an apartment in the building recently sold. You’re pleasantly surprised to learn that the price has increased significantly compared to what you paid seven years ago.
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 trapThe 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 emotiona