The Wealth Effect

The Wealth Effect

A theory stating that when security prices are rising and individual portfolios are therefore also rising, people spend more. This is attributed to the idea that when people see their net worth increasing, they feel more secure in their financial situations, and therefore act as if they were wealthy, whether or not their actually are. Absent a bear market and the subsequent decrease in portfolio values, the wealth effect is difficult to control. People will continue to spend as long as they believe they are wealthy.

It is important to note, however, that the wealth effect works in both directions. When the market is performing poorly, people tend to spend less than they actually could. See also: Behavioral economics.