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How the Reverse Wealth Effect Will Change Your Investing and Your Investments
The US stock market is entering a correction mode. There is a lot of speculation about whether this is a short-term buying opportunity or a longer term meltdown that will wipe out years of gains. Ideally, investors should use fundamental analysis of intrinsic stock value and technical analysis trading signals as guides, to buying and selling stocks, bonds, real estate and other investment vehicles. But, human nature being what it is, we invest more aggressively when the market goes up and pull back faster when the market goes down. A part of what is going on today is a reverse wealth effect. Here are some thoughts about this phenomenon and how the reverse wealth effect will change your investing and your investments.
The (Reverse) Wealth Effect
Investopedia defines and explains 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.
The wealth effect was especially pronounced in the years leading up to the financial crisis and Great Recession. Low interest rates encouraged people to buy more expensive homes than they could otherwise afford because mortgage payments were so low. Many purchased second and third homes, using equity taken out of their primary residence, because they were now “so well off.” This wealth effect also drove up stock prices past when fundamentals and technical indicators would support.