has made your profession obsolete. Any thought experiments can illustrate scenarios that can up-end your current financial outlook. If any of these happens, you might feel dejected, despondent, or discouraged, but a combination would be disastrous to many people’s psyches. The two examples above are examples of the wealth effect. The first instance is a positive wealth effect. You come across an unexpected windfall, and a vast number of options open up for what to do with the money. If enough people experience this positive effect, then this can contribute to a virtuous cycle of increasing wealth leading to more wealth. The second instance is an example of a negative wealth effect. A negative wealth effects happen when asset values contract due to circumstances outside your control. During periods of market volatility, investors typically experience a negative wealth effect. A negative wealth effect occurred during the Great Financial Crisis, where falling home prices led to a downward price spiral in other assets. People see their assets’ value falling and extrapolate further falling prices into the future. Falling prices consequently affect their wealth. Declining wealth can lead to a feedback loop that sees further economic decline if more people suddenly stop spending. This process happened during the Great Depression, and the psychological effect still occurs today. These mental exercises demonstrate the most crucial aspect of money, wealth, and investing; psychology. Psychological effects around the dynamics of money are complex and highly interdependent. People view a loss of wealth as more painful than a similarly sized gain is enjoyed. When markets are booming, people feel empowered to spend more. When markets are gloomy, the tendency to spend freely is curtailed. The interaction of psychology and money is an interesting place where we can see the limitations of our Stone Age behaviors manifest in the modern world. Behavioral economists have attempted to catalog all our illogical tendencies in the biases and heuristics literature of writers like Kahneman, Tversky, Thaler, and Sunstein. These authors observe that once-adaptive behaviors that guarantee survival in life-and-death
situations usually are maladaptive when it comes to money matters. When our brains see losses in our portfolio, we want to avoid that pain. Avoiding pain and moving toward certainty during times of volatility is usually costly, not only to your portfolio but also to your mental state. Once you start to change your plans during tough times, you are more likely to change other long-term goals, which could be counterproductive to your overall wealth. Awareness that these biases are innate to all people can help us better understand ourselves. Having an outside perspective on your financial picture can also be another way to grasp the implications of market volatility. When viewing your financial picture, it is important to understand that the long-term impact of decisions we make under duress may not be optimal. If you are having trouble sleeping at night due to financial stress, it might be worthwhile to reevaluate your financial picture. If you need to make a change, it is best to have experts who can walk you through the details and benefits before execution.
INVESTING| BEHAVIORAL FINANCE | FINANCIAL LITERACY
Negative Wealth Effect
Nate White Portfolio Analyst and Senior Project Manager
“The first principle is that you must not fool yourself, and you are the easiest person to fool.” — Richard Feynman Imagine you have just inherited a large sum of money. The sum isn’t essential, but what you can do with the money is. You might take trips. You could buy anything you ever desired. Maybe you want to devote your time and money entirely to philanthropic endeavors. If you are entrepreneurial, you might build a business that multiplies the windfall tenfold. All these possibilities are
new and exciting opportunities that didn’t exist before you came into your fortune. You feel empowered to spend, invest, and splurge without reservation. Now imagine that your accountant has not filed your taxes correctly for a few decades, and you suddenly owe the government vast sums. Or a relative has taken out loans against your jointly owned property that will be foreclosed. Maybe there has been corporate malfeasance at your employer, and you suddenly are out of work. Imagine that technological innovation
18 PERSPECTIVE Summer 2023
PERSPECTIVE Summer 2023 19
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