What is smoothing of consumption? And why is it important if you want long-term financial stability?
Consumption smoothing is a financial planning concept that was developed and tested by economists. It refers to the rather ambitious idea that people strive to maintain a relatively stable and predictable standard of living throughout their lives during all stages of life.
What is smoothing of consumption?
At its core, consumption smoothing refers to the practice of maintaining a constant level of spending or consumption over time, regardless of fluctuations in income or other financial resources. This strategy aims to mitigate the impact of income volatility, unexpected expenses, or economic downturn, thus enhancing financial stability and flexibility.
The concept of consumption homogeneity has roots in many economic theories and research, but its formalization and prominence can be attributed to economists such as Franco Modigliani and Milton Friedman.
Today you are probably adjusting consumption for short-term spending
Smoothing consumption is actually a common practice for short-term spending.
Most people get paid once every two weeks. And you can balance eating out on Friday with an inexpensive meal another night. But it’s a habit to try to spend about the same amount each week. Most people have an intuitive sense of the cash flow that enables them to achieve this.
You understand how much you have to spend each pay period and stick to those standards (give or take).
In doing so, you participate in the smoothing of consumption.
Applying consumption smoothing to long-term spending may be more difficult
Smoothing consumption over your lifetime is considerably more complicated than preparing a monthly budget. And far fewer people do it successfully. It requires a written plan, complex calculations, and the ability to see into the distant future.
Usually, people who have a long-term financial plan and act according to it, engage in consumption smoothing.
NewRetirement Planner is ideal for visualization and optimization for smooth consumption. The tool allows for variations in income and spending and allows you to try different strategies to maintain your desired lifestyle.
Financial leverages that enable smooth consumption
One way to understand consumption smoothing is to view it as a financial mechanism. The machine is supposed to provide a stable lifestyle, and you have 4 main levers to achieve this goal:
Work income: The money you earn will likely vary greatly over time and be non-existent for a large portion of your retirement.
Spending: The money you spend will also likely vary significantly over time.
Origins: Savings and other assets that can be tapped when business income does not cover expenses.
Financial Products: Investments, debt, insurance and other financial products can also be deployed to help stabilize your lifestyle.
For example:
- Insurance is used to help spread the cost of a potential event that could significantly affect your lifestyle.
- Mortgages spread the cost of your home and are one of the best methods used to smooth out depreciation. When you buy a home with a mortgage, you are borrowing money to help you achieve a much better quality of life than if you had to save up to buy it with cash.
Homogeneity of consumption at work over the life course
Young people usually rely heavily on factors such as work income, debt, and spending cuts to determine their lifestyle. Retirees live almost entirely on assets – savings as well as benefits such as Social Security and even home equity – that they have accumulated over their lives.
Consumption smoothness is about stability, not uniform levels of spending or income
There is a lot that can happen over the course of a life – whether by design or chance. Homogeneity of consumption is an ideal whereby you can live the life you want in a wide range of conditions or circumstances and regardless of fluctuations in spending and income.
Smoothing consumption involves making a trade-off
To reduce uncertainty, people often choose to give up purchasing power in the short term, and instead save or buy insurance to mitigate future risks or changes in income.
It’s about finding a life path that strikes the optimal balance between spending, saving and earning.
It is not wise to overspend and postpone saving for retirement but then have to work longer or reduce your standard of living as you age. It is also not desirable to over-save and live a meager lifestyle while working and never having fun.
Homogeneity of consumption aims at stability for an optimal standard of living.
Differences in spending
Uniformity of consumption does not necessarily mean spending the same amount every day for the rest of your life. Your spending needs will vary from year to year.
For example, you may experience a spike in spending on things like college costs or medical expenses. Your spending may decrease significantly if you slow down in the future.
Differences in income
Your income, especially your earned income, will vary greatly over the course of your life, especially in retirement when you stop working.
A reservoir of resources
Another way to understand consumption smoothing is to think about your finances no As an incoming flow and a monthly flow, but rather as a flow Large reservoir of resources Which you fill or drain throughout your life. Think about the lifetime value of your financial decisions rather than just thinking about how they affect you today.
You see, in life, you have a limited amount of time to create a limited amount of money. This money is used to finance your entire life. Spending more now means you have less to spend later. Saving more now means spending less in the near term, but more in the future.
Creating and maintaining a detailed retirement plan is a great way to visualize and manage your financial reservoir throughout your life.
Dive in! Start your tank now with the NewRetirement Planner.
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