When is Consumption Smoothing a Good Idea?
Consumption smoothing, the idea that individuals should budget to match savings and spending over their lifetimes, has been the subject of vast academic research. But a new study challenges basic assumptions and illustrates the divergence between financial theory and practical experience.
Everyone adjusts their spending and saving throughout their lives; young people borrow to pay tuition and to keep from starving, then save during prime-earnings years, then spend down those savings in retirement. Not much financial training is needed to comprehend this life-cycle pattern of saving and spending. In fact, both everyday experience and modern social science research suggest that over-modeling life-cycle consumption with complex mathematics leads to problems.
Human nature overemphasizes the relative importance of the peaks in our skill sets; call it “the prom queen theory of life.” If your most valuable asset is your good looks, you judge other people by how attractive they are and how well they dress, never mind how smart, kind, or talented they might be. And if you’re a jock, then agility, speed, and prowess on the field and court count for more than anything else; even a powerful political leader will slobber over a retired NBA point guard.
This is academic finance’s bête noir: If you solve differential equations as easily as most people brush their teeth, then you’ll liable to overemphasize mathematical complexity in the real world of investing. An apocryphal story has the search committee at an Ivy League economics department considering the appointment of Paul Volcker to a faculty position. Asks one Nobel Prize winner, “Is he smart?” Responds another, “What do you mean, is he smart? He’s the greatest central banker who’s ever lived?” “Yeah, yeah,” answers the first, “But is he smart like us?”
Trouble is, as the recent history of finance has amply demonstrated, the capital markets are not terribly well modeled by the elegant and complex mathematical equations favored by high-level academics. Put more simply, the financial markets, subject as they are to the vicissitudes of human behavior and history, do not behave nearly as predictably as do airfoils and electrical circuits. Benjamin Graham put it best:
In 44 years of Wall Street experience and study, I have never seen dependable calculations made about common stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra. Whenever calculus is brought in, or higher algebra, you can take it as a warning sign that the operator was trying to substitute theory for experience, and usually to give speculation the deceptive guise of investment.
Or, more pungently, how do you know that economists have a sense of humor? Because they use decimal points. (Alternatively: Can you spell Long-Term Capital Management?)
Yale University economist James J. Choi got to the heart of the matter in a widely reported NBER paper, Popular Personal Financial Advice Versus the Professors, in which he contrasted popular but generally well-regarded personal financial advice with academic theory, using consumption smoothing as Exhibit A.
The first economist to formally approach consumption smoothing was Irving Fisher in The Theory of Interest, originally published in 1930. Fisher’s treatment was, in the style of the time, more graphical than mathematical. The concept was then taken up by Paul Samuelson, Robert Merton, and Zvi Bodie, hyper-talented mathematicians all, in a series of papers chock full of differential equations, integrals, and in one 1969 piece, continuous time calculus. Perhaps the most famous of these was one published in 1992 by Merton, Bodie, and Samuelson’s son William, Labor Supply Flexibility and Portfolio Choice in a Life-Cycle Model, a mathematically dense treatise that integrated an individual’s lifetime consumption with the return/risk characteristics of both their investment capital and their human capital.
In its simplest form, consumption smoothing assumes that the individual’s risk tolerance remains constant throughout life, and that the rate of investment return equals the investor’s “time preference” for earlier consumption, the mathematical logic of which mandates maintaining a constant standard of living throughout one’s lifetime.
These are very strong assumptions. If you think that your risk tolerance remains constant over the years, then you’ve never invested through a real bear market. More to the point, a constant lifetime rate of consumption is a recipe for misery, as today’s wants become tomorrow’s needs and turn humans who effortlessly habituate to their material environment into hamsters on the hedonic treadmill.
Choi intuitively understands this, and his paper is surprisingly receptive to much popular advice regarding consumption smoothing (which I greeted with relief, since he cited two of my books). In an interview for NPR’s Planet Money podcast, Choi agreed with the interviewer’s observation that because of habituation, consuming at a low level while young, then gradually elevating one’s material lifestyle later might “boost your total lifetime happiness.” Choi further emphasized the importance of establishing a strong savings discipline early in life, even at the cost of depriving one’s younger self: “When I was a Ph.D. student and had a very low income, I didn’t take on debt [as recommended by consumption smoothing]. I saved a little bit of money during my Ph.D. years, and I didn’t feel like it was deprivation. I had low income, everybody I hung out with had low income; we were students, and it was fine.”
And while that’s at variance with conventional academic finance advice, most economic historians would likely agree with Choi. Richard Easterlin, for example, famously observed that as societies grew wealthier, they didn’t become any happier. Over the several decades since 1950, for example, inflation-adjusted Japanese incomes increased by an order of magnitude as they graduated from postwar starvation to the front ranks of OECD living standards, yet their aggregate well-being metrics failed to budge. In Growth Triumphant, Easterlin demonstrated just how quickly people’s material expectations evolve by quoting an Indian peasant circa 1960 who earned about $10 per month:
I want a son and a piece of land since I am now working on land owned by other people. I would like to construct a house of my own and have a cow for milk and ghee. I would also like to buy some better clothing for my wife. If I could do this, then I would be happy.
At the opposite end of the spectrum, consider economic journalist Megan McArdle’s observations from a 2012 Atlantic article about her disastrous encounter with the academic life-cycle wisdom she and her fellow University of Chicago MBA students imbibed during the roaring 90s:
We made only the most erudite and sophisticated sorts of mistakes, like gang-rushing banking internships, and telling ourselves we were “consumption smoothing” as we used student loans to finance vacations. Believe it or not, many of us talked frequently about the echoes of 1929 – but we still didn’t necessarily act on that insight, as the markets cratered in the early 2000s.
Obviously, there are times when one has to borrow; a mother down to their last penny may be forced to borrow at loan shark rates, or even steal, to keep her children from starving. On the other hand, only a fool incurs revolving credit card debt to fly business class.
Several decades ago, Abraham Maslow provided a useful shorthand for dealing with smoothing with his famous pyramid of needs.
To wit, if someone cuts off your air supply, you’ll forget about the fact that you’re hungry, thirsty, or desperately need to pee. These physiological needs form the base of the pyramid. After you’ve satisfied them, your concerns move up to the next level: basic shelter and freedom from imminent violence. Then on to the desire to be loved, then to be respected, and finally to transcend our own needs and concentrate on the rest of humanity, like Gandhi, Martin Luther King, or Sam Bankm . . .oh, wait.
This image provides a handy way of thinking about lifetime consumption: The further up the pyramid your marginal consumption is aimed, the less you should smooth.
When thinking about smoothing, keep in mind the final passage from Easterlin’s marvelous book:
In the end, the triumph of economic growth is not a triumph of humanity over material wants; rather, it is the triumph of human wants over humanity.
William J. Bernstein is a neurologist, co-founder of Efficient Frontier Advisors, an investment management firm, and has written several titles on finance and economic history. He has contributed to the peer-reviewed finance literature and has written for several national publications, including Money Magazine and The Wall Street Journal. He has produced several finance titles, and four volumes of history, The Birth of Plenty, A Splendid Exchange, Masters of the Word, and The Delusions of Crowds about, respectively, the economic growth inflection of the early 19th century, the history of world trade, the effects of access to technology on human relations and politics, and financial and religious mass manias. He was also the 2017 winner of the James R. Vertin Award from the CFA Institute.