Psychology or the role of emotions in economic decisions is already accepted. We don’t always buy at the best price. Nor do we maximize benefits when we make our decisions for consumption or investment.
One psychological phenomenon is the effect of rising stock or property prices on the investor. He is apt to spend money he doesn’t really have yet, simply because he feels richer from his paper profits. The green numbers become his go signal to step on the accelerator of his spending motor. This urge to splurge is irrational as the actual cash is still unavailable, and may not even be as much as expected when the asset is sold.
Economists explain the increase in consumer spending during a bull market as the “wealth effect.” When paper (and still unrealized) profits accumulate in one’s stock position, the exuberant, though unfounded, feeling of wealth sets in. This leads to the consumption of luxuries like cars, gadgets, couture clothes, jewelry, and foreign trips. The feeling of prosperity can drive consumption, usually fueled by credit card spending premised on future windfalls.
What if the stock market is volatile and on a downward trend as it can be for long periods, coupled with the recent depreciation of the peso to four-year lows, does this same investor now feel poorer and experience the opposite “poverty effect?” If the investor is trading on margin, the poverty may be more real as his position is sold off and the losses kick in faster.
The poverty effect lies in the realm of emotions. It is quite different from real deprivation, a state where even basic goods like food and taxi fare cannot be purchased or consumed. Still the poverty effect affects both real and imagined reduction of disposable income.
Signs of the poverty effect, whether psychological or real, are hard to miss.
Indifference to good news is pronounced.
There is little appreciation for statements on the drivers of growth remaining intact and unappreciated. The rallying cry of infra spending “build, build, build” seems a mockery of the personal mantra of shrink-shrink-shrink. Property marketers use the malls to give away brochures on unsold inventory “for investment.” Pre-selling of condo units on a three-year delivery are not stoking interest, as seen from their flat prices, even with no-down-payment installment offers.
Even large corporations tend to hang on to cash and extend their payments to suppliers like security services and landscape architects. This postponement, if not deep discounting, of bills creates the illusion of having more cash on hand from de facto suppliers’ credit. The poverty effect also applies to companies after all.
Business swings involve an outlook and a mood.
Since a rise in foreign direct investments or the opening of a major call center by a foreign company is not easy to arrange, some other kind of psychological lift is needed to perk up the economic mood and overcome the poverty effect. Political infighting, Senate investigations, and rising body counts add to the distraction on positive business news.
Preventing the poverty effect in taking root entails showing more than GDP numbers and the usual economic metrics like inflation within the BSP range, although in the upper levels. There is an emotional component similar to a recently wealthy individual feeling uncomfortable he will continue to live in his new house.
Still, there’s nothing really wrong with feeling a little pinched. It may turn cash (and savings) into a viable portfolio component again. However, it is consumption and the feeling of wealth that truly spurs the economy, as Keynesian economists will argue.
It is good to remember when the market is down that it is not what you lost but what you still have left that counts. For the “buy and hold” followers of the philosophy of Warren Buffet, declining stock prices are just paper losses.
Even optimists though soon stop advising the strategy of “averaging down” or buying the same stock at declining prices. Less popular as a strategy is “averaging up” or selling as the price rises and not waiting for the target price to be breached. Somehow, the latter may be there for the longer haul.
The poverty effect takes hold when it is time to cut losses and sell the stock. Even emotional states can turn real when the cash balances turn a different color… like the eyes of an insomniac.
A. R. Samson is chair and CEO of Touch DDB.