The Wealth Effect - Are We Really Richer?

Here's a little recipe I've been thinking about that's part physics, part human nature, part financial common sense.

First the physics part, courtesy of Sir Isaac Newton's first Law of Motion: 


In other words, an object that is at rest will stay at rest unless an external force acts upon it. Unfortunately, this universal truth holds true for many of us humans as well, especially when it comes to planning our futures!  Let's face it, when our portfolios are skyrocketing every time we log in to check the balance, that little voice in our heads says "leave it alone, you're doing great!"

This is known as the "wealth effect", which states that we all "feel" richer when we see our paper assets going up, but in reality, we're not really richer until 2 things happen: 

  1. we sell all of our paper assets for cash (usually denominated in dollars) and
  2. we purchase something with those dollars that costs the same as it did before everyone got richer.

As we all know, the US dollar is a FIAT currency, meaning it is only legal tender or "valuable" because our government says so. It's no longer tethered to anything of real value, like it was before 1971 when we were on the Gold Standard.

In an effort to re-stimulate the economy and pay for the 2008 financial bailout the Fed has been literally printing $85b per month for the past 2 years. Since the paper dollars don't need to be backed up by anything "real", the presses just keep on rolling.  

Now for the financial common sense: Uncle Sam says that inflation is under control, and that $100k today is worth the same as $100k yesterday. But this simply isn't true. With so much more money in the marketplace, stock prices have risen, interest rates have remained low, and everyone feels richer, although there remains the same amount of desirable "stuff" in the marketplace (houses, cars, retirement destinations, etc.). Do things feel just a little pricier to you? Food?  Your kid's tuition? The houses on your block? They do to me. 

When the stock market dropped 35% in 2008, the headlines reported that $1.2 Trillion of "wealth" was wiped out, but the reality is this wealth was never really there... it was made of air, which is why they call it a bubble. Hence, the fundamental principle behind "real asset" investing: Allocate a portion of your portfolio to direct ownership of tangible goods or services that retain their value and usefulness regardless of what happens in the “paper” equities markets. Real estate, precious metals, commodities, and oil/natural gas are all examples of this. 

Next time we'll discuss our favorite "real asset" classes as well as the difference between direct ownership and ownership by proxy through vehicles such as REITs and ETFs.

If you are not willing to risk the unusual, you will have to settle for the ordinary.
— Jim Rohn