Mass psychology is what plays a key role in driving financial markets – is an oft-repeated maxim of investment experts. Be it a bull phase or bear phenomenon; it is the herd mentality of investors that sways sentiment from one extreme to another.
Sample this: During a fall of markets, investors’ psychology triggers a decline in overall spending pattern. So, investors – on account of fall in prices of their shareholdings -- tend to spend less. This is also known as reverse wealth effect.
In other words, they refrain from spending much as a result of their declining wealth notwithstanding any fall in their income. “This behaviour of spending less arises out of insecurity without any rational basis. Often times, this pattern of lower spending undergoes a change no sooner than the market moves in the opposite direction,” said Monica Sharma, a Delhi-based psychologist.
In this principle of reverse wealth, demand and consumption decline because investors feel poorer than they were earlier, reducing their propensity to spend on avoidable things such as on vacation and car, etc.
“When you realise that your investments have fallen considerably — by 20-30 percent, you tend to compensate for this by either earning more or by cutting down on your expenses. And more often than not, one can’t increase the income on your whim, so you end up cutting down the expenses,” said Deepak Aggarwal, Delhi-based financial advisor and chartered accountant.
On the contrary, consumers enjoy newly-acquired spending power in the wake of rise in asset prices such as stock, mutual funds and gold. That is known as wealth effect.
Effect of monetary policy
Sometimes central bank’s policies result into curbing some of the spending in the economy. As we know central bank deploys monetary policy to regulate inflation and raises interest rate when inflation is above its comfortable range and conversely – slashes the rates in case of lower prices.
Rate cuts are followed by increase in prices, and investors feel wealthier than earlier, resulting into wealth effect.
Even famous economist Alan Greenspan, former Fed Chairman, had once said that when people make considerable capital gains, a portion of it leads to an increase in demand and boosts consumption. But supply may not rise in the same proportion that causes inflation.
It is not merely the actual profits you make on your equities or other assets. Even when you have not earned the gains, the positive feeling one gets from notional gains earned through a bull run can induce investors into spend more.
On the other hand, when the rates are raised amid red hot inflation, asset prices fall and consumers feel their wealth being eroded, albeit partially. This, in other words, is known as reverse wealth effect.
The wealth effect and reverse wealth effect are used in developed economies where financial investments are more widely held. In India also, it matters to some extent.
So, if inflation has to cool down, reverse wealth effect has to come in the picture.