What Is the ‘Wealth Effect’ and Why Does It Matter?

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Much has been written about the trap of lifestyle inflation, but a related pitfall that can be just as dangerous, yet easier to miss, can ensnare you at the moment you achieve financial stability.

It’s called the wealth effect, and if you’re finally starting to gain a healthy financial footing, beware — it could be your hidden nemesis. 

Lifestyle Inflation: Earn More, Spend More

Earning more is one of the surest ways to improve your financial standing — unless your spending rises with your income. It’s called lifestyle inflation, or lifestyle creep, and according to CNBC, it keeps countless people from getting ahead, regardless of how much they earn. 

When someone gets a raise or a promotion, they can suddenly afford the things that they couldn’t last year, and their newly padded paycheck becomes stretched as thin as the previous one — but at least they have plenty of shiny new things to show off to the neighbors. 

The simplest way to avoid it is to retain your current lifestyle and spending throughout your career and bank the extra bucks. However, a related, yet sneakier culprit isn’t so easy to see or sidestep — and it plays on the same psychological forces.

Is Your Net Worth Finally Above Water? Don’t Let the Wealth Effect Sink You.

The Wall Street Journal recently profiled a phenomenon that’s similar to lifestyle creep, but it strikes when you become richer on paper rather than in practice. 

It’s called the wealth effect, and it induces overspending when a person or household finally achieves a positive net worth. Paying off a mortgage might be the catalyst, as might eliminating debt or earning returns in a retirement portfolio. 

Either way, the outcome is the same. The person attains a positive net worth when their assets finally outweigh their liabilities and feels wealthy for the first time — and wealthy people have money to spend. 

Just like lifestyle inflation, the wealth effect can trigger financial overconfidence that manifests as irresponsible overspending with similar results — a positive change that spurs negative behavior. 

Trapped Wealth Doesn’t Count as New Spending Money

While achieving a positive net worth more than justifies a celebration or a modest splurge, the author cautions that what starts as little luxuries can grow into unsustainable spending. Unlike lifestyle creep, where a raise supports increased spending that keeps the higher earner living paycheck to paycheck, the wealth effect usually leads to debt. 

Since things like home equity and 401(k) investment gains are hard to access, the wealth effect leads people to borrow to finance the lifestyle they imagine their newfound net worth deserves.

The end result is a big step backward and a net worth that is, once again, a negative number.

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