The Wealth Feedback Loop

Engineers often utilize feedback loops when designing control systems.  A feedback loop is a control that integrates the system’s output back into an input stream to control future operations.  Here are some common examples of a feedback loop:

  • Your home’s thermostat: As the temperature drops below a set target, the thermostat provides input to the furnace to activate and warm your home.  When the temperature climbs above the desired setpoint, the thermostat signals your furnace to turn off.
  • A microphone sends an input signal into an amplifier/speaker and the speaker generates sound. If the microphone is held too close to the speaker, it captures the sound from the speaker and creates an unintended “circular” loop; this generates an unpleasant “squeal” we are all familiar with.
  • The NFL draft: Every year, teams with the worst record are provided the earlier opportunities to select the best players coming out of college. As these teams “rebuild” with more talented players, they should eventually improve their win-loss record and move down in the draft (in theory).

In finance, the “wealth effect” is a type of feedback loop that influences an individual’s own financial decisions and actions.  Home values are one area where the wealth effect can be observed.  As home prices increase, consumers feel emboldened to increase spending even if their actual income and cash flow remain stagnant.  This drives economic growth which supports home prices moving even higher.  A positive (but unsustainable) feedback loop.

Investment assets can be another source of “wealth effect”.  One can log-on to their 401K, brokerage, savings, and other accounts to see real-time account values.  We can track and monitor wealth like never before.  By contrast, one does not receive a fresh appraisal on their home daily (not even Zillow).

Economists are noticing a shift in the wealth effect for younger generations.  Whereas the baby boomer generation prioritized purchase of a house and later built an investment portfolio, the average millennial is more likely to pursue establishing an investment portfolio for several years prior to purchasing a first home.  Financial assets, rather than home equity, are a bigger driver of wealth for the millennial generation’s perception of overall wealth.  As millennials begin to build and inherit more wealth, economists believe this feedback loop may alter consumer spending habits.  As markets advance, the perception of wealth increases, which boosts consumer activity, which may further advance markets.  Of course, the opposite can also occur.  When markets retreat, wealth perception decreases, which may reduce consumer activity, which may in turn drift markets lower.  Feedback loops can be self-fulfilling and amplify economic swings in both directions.

It is important to balance significant financial decisions with actual income and cash flow (not solely based on unrealized gains within their portfolio) to manage living expenses.  It is unwise to rely on unrealized gains in portfolios to create a lifestyle which is challenging to sustain through the inevitable ups and downs of the financial markets.  It could also explain why some behavioral economists observe younger generations may invest more conservatively (and sacrificing longer-term growth potential) than their parents might have at the same stage of life.  Recall hearing the saying “act your wage”?  Wise words to remain grounded and avoid becoming a victim of a noisy wealth feedback loop.

-Jordan Ranly | Nvest Wealth Strategies, Inc.
Posted in Blog Post, Personal Finance.