Consumption Smoothing and Why It Doesn’t Work

When I was a young professional, my income was relatively low – substantially lower than it was even five years later. I knew that over time, my income would go up; my career path offered lots of opportunities for growing one’s wage and I was dedicated to my career.

So, like many young professionals, I justified a lot of overspending with the excuse that I would be earning a lot more in the future and could make up for my spending then.

This is a well-known economic concept called consumption smoothing. In a nutshell, Consumption smoothing means balancing out spending and saving to maintain the highest possible standard of living over the course of one’s life.

The big reason in favor of consumption smoothing is that it in theory balances between the two extremes. On one end, overspending means that you consistently spend more than you earn, while oversaving means that you consistently spend less than you earn.

My argument, early on, was that I should overspend while I was a young professional and that I would spend less than I earned later on when I was earning more. This would allow me to have the same quality of living now that I would have later.

There’s a big problem with all of this, though: life happens. Seven years ago, I was unmarried. Five years ago, I was childless – my wife wasn’t even pregnant yet. Three years ago, I lived in a tiny apartment. Two years ago, I had a full time job with a large organization. Heck, three months ago we didn’t know we had a third child on the way.

Beyond that, I’ve watched my friends pretty much stumble onto successful dot-coms. I’ve watched other friends come down with life-altering illnesses. I’ve watched friends fall in love. I’ve watched friends get divorced. I’ve watched friends discover children they didn’t know they had.

Consumption smoothing only works if you can exactly predict the way your life will go. And you can’t. Life is too unpredictable for that.

My philosophy is much simpler: just consistently spend less than you earn and save the difference. If you’re early in your career and not earning much, these should be your salad years. When your life changes – you’re earning more and you have more responsibilities – spend more.

Spending less than you earn and saving the difference provides a much more important kind of smoothing, what I’d like to call “risk smoothing.” If you have money in the bank, it’s a lot easier to take a risk and start a new business. If you have money in the bank, you are much more likely to roll through personal crises.

This isn’t a call to “oversave” – that’s unhealthy. Just consistently save some percentage of what you earn – you can figure out what works in your own life. Then, when you need it to take advantage of the great opportunities life hands you or to deal with the problems that come up, it’s there for you.

Or, you can sit at home with your 72″ television while lamenting the fact that you missed out on the opportunity of your dreams.