Peak Earnings, Peak Pressure: Why Does "Making More" Not Mean "Feeling Richer"?

Many people are at least somewhat familiar with the ideas that have gained prominence under the umbrella of behavioural economics. A subset of that is known as behavioural finance. There are literally dozens of examples of behavioural shortcuts (known as heuristics) that explain how people make financial decisions. Many of these decisions are either brazenly irrational or only conditionally correct. Some of the outcomes are comical, while others border on tragic.

Many books have been written about behavioural economics, and it makes for fascinating reading because it's the intersection of personal finance and social psychology with a pinch of zeitgeist thrown in. It's been well established that most people fancy themselves to be rational, self-interested decision makers (a group that Nobel Prize winner Richard Thaler mockingly refers to as “econs” because they don’t seem to exist in the real world). In fact, most people are merely human, with all the foibles, blind spots, and quirks that entails. The simple fact is that people seldom make their decisions based on a cold, rational assessment of the facts at hand. Instead, they make emotional and contextual decisions that are often counterintuitive and self-harming.

One of the most interesting elements of this phenomenon is known as the wealth effect. Explained simply, the wealth effect says that people behave differently simply because they feel wealthy. When people feel richer, they behave differently.  When their assets rise in value, they tend to spend more and save less. This happens even if their current income hasn’t changed, because higher net worth boosts confidence, expectations of future income, and sometimes, borrowing power. Conversely, when asset prices fall, people feel poorer and often cut back on spending.

Some Real-Life Examples

Let’s look at a few examples.  Here’s an obvious one. Say the stock market rallies. The run-up will create higher portfolio values, and as investments increase in value, many people may feel wealthier. As a result, they may decide to take a vacation, buy a new appliance, or upgrade a car. The result is higher consumption driven by perceived wealth rather than new income.

A similar example (until very recently, at least) is the rising real estate market. As housing wealth rises, a homeowner’s equity grows. As a result, they might refinance to pull cash out, fund renovations, or make debt-financed purchases.

It can work in the opposite direction, too.  If wealth declines, people often reduce their spending. During a stock market crash or housing bust, people feel poorer and so delay big purchases or save more, which can dampen economic growth.

The strength of these effects varies: they’re typically stronger for households with large illiquid wealth (like real estate) and weaker for those who rely mainly on current income or have high debt obligations.

None of this has anything to do with income.

It should be obvious that this isn’t really about numbers.  It’s mostly about vibes. There are plenty of couples in Canada, where the combined income might be over $300,000 (i.e. high enough to qualify as accredited investors with access to more supposedly sophisticated products), yet many of these people still feel stretched.

I recently met with a couple who are both dentists and who are legitimately having a hard time making ends meet despite a combined income well over $500,000.  They have a large mortgage, two children in private schools and a massive student loan (from a major U.S. university) that needs to be paid off.  Their combined income is massive, but so are their combined monthly payment obligations.  With real estate values being flat at best, an investment in their children’s future being something that has no direct payoff to them personally, and repaying student loans that were a necessary evil required as a precondition to earn a massive income, the vibes are decidedly muted. For them, life feels a bit like the U2 song, “Running to Stand Still”.

Granted, some will say the problem didn’t have to be so pronounced.  They could have bought a more modest home. They could have put their kids in public school. The criticism largely misses the point, however.  It’s not that they can’t make their payments; it’s that they can’t make the kind of headway that others with a lesser income can make simply because they made choices that are commensurate with (i.e. not in excess of) their cash flow.

There is an oft-quoted line from Charles Dickens's novel, David Copperfield. It’s spoken by the character Mr. Wilkins Micawber, and is often cited to illustrate a hopeful, almost-utopian view of budgeting. The most quoted version is: “Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness.” While there isn’t a canonical continuation in Dickens’s text, some people later paraphrase or joke with versions that talk about misery being the result if the expenditure is over twenty pounds.

The point in this is that the vibes are not only the result of income, but rather the result of net free cash flow; the amount left over after all the obligations have been attended to. There’s a Canadian bank that has spent a generation telling us that we’re “richer than we think” by piggybacking on this ethos. 

Conclusion

While much of personal finance is about hard numbers like tax brackets, your ability to save is a real consideration in how secure you feel.  Having an affluent lifestyle is somewhat misunderstood. While the term affluent (adjective) is usually defined as: having a lot of money and goods; wealthy or well-off, it can also be defined as “a stream that flows into another”. 

In other words, affluence is a flow, while wealth is a stock.  The wealth effect is about leveraging the stockpile of assets you have built up and the comfort and confidence that comes from having done so. It comes irrespective of how much money is flowing into your account regularly. Having a strong income often has no bearing on the vibes of how wealthy or secure someone feels.

John DeGoey is a Portfolio Manager with Designed Securities and the host of the Make Better Wealth Decisions podcast. The opinions expressed are those of Mr. DeGoey and may not be shared by Designed.