The Wealth Effect
What it is:
The wealth effect is an increase in consumer spending directly proportional to strong portfolio performance.
How it works (Example):
The wealth effect is a behavioral economic theory which posits that consumer spending increases significantly when overall portfolio performance is high. During a bull market, portfolio values rise to high levels. Portfolio holders, consequently, perceive themselves as more affluent. Psychologically associating higher net worth with having more disposable income, consumers increase their spending.
Why it Matters:
The wealth effect is believed by many economic analysts to be the reason why significant interest rate and tax increases associated with bull markets have, historically, had little effect on levels of consumer spending. The psychological components of the wealth effect can inversely affect a bear market as consumers engage in lower spending. This comes as a result of consumers feeling they do not have enough money due to significantly lower portfolio values.