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Keep Your Cool Amid Wealth Effect Reversal

I don’t know about you, but for me, the wealth effect is real.

If you haven’t heard of this behavioral theory, it refers to the change in spending that accompanies a change in perceived wealth.

The idea is that consumers feel more financially secure and confident when their homes and investment portfolios are rising in value. They feel richer, even if factors such as their income remain unchanged.

And it makes sense, right? When you feel richer, you’re likely to spend more.

In my case, the wealth effect rings true. When I’m making money in the markets, I’m spending more money. For instance, sometimes I'll have a trade that goes well and reward myself—I’ll buy a watch or some clothes.

Keep in mind, I don’t spend a lot of excess money, but when the wealth effect kicks in, I find myself being a little less frugal.

"It's time to buy - I can prove it."
—Jared Dillian.

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The Wealth Effect in Reverse

Now, it probably comes as no surprise to hear that the wealth effect is moving in reverse right now.

Sentiment is down, as the stock market is about 20% in the red. Not great, sure. But in the context of all the bear markets throughout history, it’s not horrible.

I mean, we've had much worse bear markets (e.g., 1929, 1974, 2001, and 2008), including instances when stocks were down 50%+. This isn't one of those times.

But what makes this unique is it’s the worst year for the bond market since 1788—since the year after the Constitution was drafted!

So, what we have is a destruction of wealth in the stock market and an even bigger destruction of wealth in the bond market. And combined, we have a destruction of wealth that mirrors the financial crisis.

That’s Not to Say You Should Panic

A lot of financial stress is your attitude. You can choose whether you stress about this stuff or stay levelheaded.

I’ve been through a lot of bull and bear markets. I've been through times when I felt rich and times when I felt poor. Right now, I’m feeling poor.

But at the end of the day, a 20% drawdown is not that big of a deal. I mean, it's a big deal, but we're going to survive it… just like we survived the explicit lyrics of the ’90s.

So, stay active. Keep sending in those checks. And keep investing in all environments to realize a positive average return over time.

Looking ahead, I think there’s a reasonable chance for new highs next year. And I know it can feel counterintuitive to invest during a bear market. It feels terrible. It feels like the exact wrong thing to do.

But let me tell you, when everyone else in panicking, it is the exact right thing to do. Here’s why.

Jared Dillian
Jared Dillian

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