In economics, the wealth effect is used to explain the increase in spending that results from an increase in perceived wealth.
In easier to understand personal finance language, the wealth effect occurs when your net worth increases due to an increase in home or stock prices. This increase makes you feel richer, and therefore causes you to increase your spending.
For example, if your home was worth $200,000 last year and home prices rise 10% the following year, your net worth increases by $20,000. The increase in net worth, makes you feel $20,000 richer. Unfortunately, you begin to spend like you’re $20,000 richer.
The wealth effect is a potential pitfall of choosing to calculate your net worth on a regular basis.
How to Avoid The Wealth Effect
Common sense tells us that spending should rise only with an increase in income, rather than in increase in net worth. Here is how to avoid this trap:
Problem # 1 – You think you’re richer from an increase in assets that you can’t live without and/or would never sell.
Solution – Don’t include any assets that you can’t live without or would never sell in your net worth calculation.
Previously, I used to include my home’s value as an asset while calculating my net worth. However, I started to think of the purpose behind performing a net worth calculation – I wanted my net worth to be an accurate measurement of my wealth.
If I were to sell my home today, it would require a major lifestyle change. One that for me personally, I don’t want to go through. Since I wanted my net worth to be an accurate measure of my current wealth, it made sense to no longer include it. (Of course, I still include my mortgage as a liability)
The same can be said for my car. I need my car to drive to work each day. I live in an area and have a job where taking public transportation isn’t an option. For my situation, I couldn’t live without a car and maintain the same lifestyle. Therefore, I don’t include it in my net worth.
Last, I could pad my net worth by including assets I would never sell such as my wedding ring or furniture. Again, since I would never sell these items, I don’t include them in my net worth.
Problem # 2 – You feel richer from an increase in your portfolio.
Solution # 2 – Separate and track changes in current and long-term assets.
The value of your 401K and IRA increasing should have no effect on your spending today. Yet, the wealth effect has shown that there is a correlation between stock prices and an increase in spending.
While calculating your net worth, it’s important to separate current and long-term assets for an accurate reflection of your wealth. Now, if there is an increase or decrease in your net worth, you can identify where it came from.
The goal is to see consistent growth in both asset categories.
The freedom to increase your spending shouldn’t come from an increase in assets such as your home and investment portfolio.
Next time you calculate your net worth, make the above changes. Does it give you a more accurate measure of your wealth?