How to Avoid the Negative Influences of the Wealth Effect

Did you know that recessions are good for your savings account, but a booming economy tends to drain your savings? It’s true.

In April, 2005, when the stock market was booming, personal savings in the United States dipped to 1% but jumped to as high as 6% during the recent recession.

Why this phenomena? Because we instinctively cling to what we have when times are tough, but we also loosen those purse strings when good times return. Meir Stratman, a behavioral finance expert at Santa Clara University, explains that this tendency, known as the wealth effect, has occurred predictably during past recessions and recoveries. The wealth effect occurs because we allow our feelings to trump our financial logic: when we feel threatened we save, but when we start to feel optimistic we spend.

With the worst of the recession over, it is time to guard against the wealth effect in your own life. Because you don’t want to wake up a year from now wondering how your savings dissolved and your debt grew, you need to become pro-active today. The following hints will help you keep your savings and spending on track.

1Make Saving Automatic.

If you saved when you felt threatened, you will default to less saving when you feel optimistic. You therefore need to remove your emotions from the equation by making your savings happen automatically. It’s simple: have a portion of your income deposited directly into your savings account.

2Give Your Savings a Name.

When recessionary fear no longer drives you to save, you need a positive motivator. Giving your savings a name will do it. Be creative: call your emergency fund your unemployment account. Saving for a car? A car fund is mundane, but what if you called it your paid-for-Honda-Pilot account?

3Agree With Your Spouse.

Being on the same page is essential anyway, but becomes critical in case one of you starts to waver. Your agreement means that the two of you will keep each other accountable.

4Put Your Goals in Writing.

Putting your goals in writing makes the difference between hoping something will happen and making it happen.

5Start a Budget.

This is another way of writing it down. You have a much better chance of controlling your spending when you have a written plan.

6Use Cash.

Studies show that people spend more with plastic than they do with cash. Plastic, on the other hand, moves you a step away from the reality of the purchase. More distance = less pain = more spending.

7Have Agreed Limits With Your Spouse.

The two of you need to agree to an amount each other can spend without spousal assent. Whether this amount is $25 or $500, just be sure to agree.

8Plan to Spend.

After exercising lots of self control during tough economic times, some people fall of the wagon, splurge, and then wonder what happened. Sound familiar? You can offset this tendency by giving yourself a budgeted amount of money to spend at will. Simply write spending money into your budget and pay yourself a monthly allowance . . . always cash of course. This relief valve will prevent big explosions.

As the recession comes to an end, the wealth effect will try to sneak into your life. If you are proactive today, you will avoid its negative influences.

Are you avoiding the wealth effect? Leave a comment!

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