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.