Consumption smoothing is the idea that your spending or consumption should be relatively similar throughout your life. That means when you are earning lots of money, you only spend a small part of it and when you aren't earning much, you borrow or use your savings to fund consumption.
It seems wise at first glance — you always get to spend the same amount of money, but in practice, it is a really bad idea. I'm not the only one who thinks so and my review (actually written months after this post was) of Jonathan Clement's book How to Think About Money (with a foreword by Bill Bernstein) showed me that at least two other smart people agree with me. Here's what Dr. Bernstein had to say about it:
Academics tout the tide of so-called consumption smoothing: borrowing heavily when you're young, then paying off those debts when you're old, so as to maintain a constant standard of living throughout your life. This is a really, really dumb idea, since it ignores habituation: Get used to the Beemer and business class when you're young, and by the time you're middle-aged you'll need a Bentley and private jet. My medical colleague and fellow financial author Jim Dahle advises newly established doctors to continue “living like a resident” for several more years after starting practice. That's good advice for just about everyone else too: Get used to Motel 6 when you're young, and when you're older and richer you'll pinch yourself every time you check into the Radisson.
Later in the book, Clements says this on the subject:
At issue here is the so-called hedonic treadmill or hedonic adaptation. The notion: We aspire to get that next promotion and, initially, we are thrilled when the promotion comes through. But all too quickly, we adapt to our improved circumstances, we take the new job for granted and soon we're hankering after something else….The process of striving for material improvements, and then quickly adapting to those improvements, makes it difficult to achieve permanent increases in our level of happiness.
If you look around, you will see examples of consumption smoothing all over the place. It manifests itself with medical students going on vacations paid for by student loans, residents driving cars they can't afford until they're ten years out of residency, and with new attendings buying a house with zero down despite having a net worth of -$400,000.
There are obviously some valid uses of debt (consider how student loans may increase your career earnings by five times what they would be if you never went to medical school). In addition, savings are extremely useful in times of job loss, financial stress, and certainly during retirement. Despite these facts, consumption smoothing is a terrible idea for three reasons.
# 1 Consumption Smoothing Messes Up Your Mindset
There is a certain mindset required to become rich/wealthy/comfortable etc. Just about every self-made millionaire shares the same traits and mindset. They work hard, they save money, and they practice frugality, especially when young.
Consumption smoothing encourages you to never really develop this mindset. Like the little red devil on your left shoulder, it tells you to “Go ahead and buy that Mercedes, you're a doctor and you'll make plenty of money eventually. You deserve it.”
Someone with a consumption-smoothing mindset instead of a wealth-building mindset is unlikely to ever build the wealth that would actually allow for consumption smoothing.
# 2 Spending Is Like Narcotics
More importantly, as mentioned by Bernstein and Clements above, the main problem with consumption smoothing is hedonic adaptation. If you are living like an attending as a resident (you know, staying at the Radisson), there will be no reward later for all your hard work.
Spending and consumption are like narcotics. Not only can you become addicted to them, but you gradually become tolerant, such that the same amount of spending no longer brings the same level of happiness. So if you spend the same amount throughout your life, your happiness, at least as far as it can be purchased with money, will actually decrease due to this increasing tolerance.
Want to have “happiness-smoothing” throughout your whole life? Then set up your finances so you can spend a little more each year. That means you had better start out spending very little early on, which is the exact opposite of consumption smoothing.
# 3 Consumption Smoothing Encourages You To Borrow Too Much
Another big issue with consumption smoothing is that it requires a great deal of borrowing, at least in the beginning, and then you spend the rest of your life paying back that debt from your youth. Some people are huge fans of debt and barely even make a distinction between good debt and bad debt. Others are rabidly anti-debt, since “the borrower is slave to the lender.”
I'm more of a “debt is a necessary evil” where I can justify a few debts but they should be few and far between, at the best possible terms, and paid off relatively quickly unless there is some obviously better use for the money (like getting the match in a 401(k) or perhaps maxing out retirement accounts.)
The problem with debt is it locks you into a pathway. When you borrow $450K to go to medical school, well, guess what you're going to be doing for the next 20 years whether you want to or not? That's fine if it is what you want, but too often, it isn't.
In reality, when you borrow you aren't borrowing from the bank or the federal government. You're borrowing from “Future You.” And Future You may not appreciate the amount you borrowed or the terms you agreed to. You would do well to assume that Future You would like to take even nicer vacations than you like, drive an even nicer car than you drive, and have fewer financial worries than you have.
Besides, life changes. Maybe you want to change careers. Perhaps you become disabled, or divorced, or widowed. Maybe you have a special needs child. Maybe your expected income gets halved. In all these situations, the goal level of spending you are “consumption-smoothing” to will be too high. Now what? You're hosed, that's what.
Consumption smoothing is a bad idea. People are not automatons and life changes. Start your adult life with very frugal habits and you will always feel wealthy.
What do you think? Do you believe in consumption smoothing? Why or why not? Why do doctors and other high-income professionals get suckered into this? Comment below!
Happiness is relative. If life is the same for your entire life then you likely won’t be happy. You need ups and downs. Financial up and downs are just one manifestation of that need. Without the rewards of a changing spending level over time you will, as you noted, grow tolerant to them. Happiness is the point after all.
Absolutely, absolutely, agree that one shouldn’t borrow money to fund consumption… And for all the good reasons you give.
But can I suggest that it does make sense to save windfalls and to recognize that often (usually?) a high income is temporarily?
I make this comment because some researchers like David Splinter and Thomas Hirschl consider this sort of savings to be a form of consumption smoothing, too. (Won’t link to the post, but this is what I blogged about in first week of December…)
A couple of interesting facts about high income and windfalls: A top one percent income recipient typically sees his or her income drop by about 60% ten years out… The average person has about an 11% chance of someday joining the top one percent–if only briefly.
I guess my focus was more on the front half of consumption smoothing, not the back half. I’m less worried about a high earner who wants to save big.
Actually, my beloved late husband and I (both economists, by the way) had a different kind of consumption smoothing philosophy than you describe. Never forget how much joy you managed to have living on a shoestring grad student budget and when your income increases after that, don’t ratchet up your spending automatically when your income increases. Due to vicissitudes of complicated careers, our incomes fluctuated drastically but this philosophy has stood our family in good stead. In retirement, I am able to live comfortably and have resources with which to make a small difference in the world.
Have you always been this ornery? 😉
Of course, I agree with you on the notion that spending big as a student or resident in anticipation of earning a big paycheck later on is foolish. Several residents in my program were leasing luxury vehicles to make the one to two mile commute to the hospital. I figured their parents were rich, but looking back, I’m guessing debt played a larger role than I realized.
The opioid analogy is perfect. With opioids, you quickly become tolerant to the high, but tolerance to the ugly side effects (respiratory depression, GI sx) develops much more slowly. With spending, tolerance develops quickly to the upgraded item / lifestyle, but the downsides like debt and an unfunded retirement are easy to dismiss.
Never change your cantankerous ways!
-PoF
Must have been feeling really feisty a few months ago when I wrote this.
I wish I could edit my comment. I read the post, wrote the comment, clicked post, and then re-read the post.
What I would like to say now is that consumption smoothing is probably bad if it’s really an excuse to borrow for consumption. But consumption smoothing is probably good if you’re smoothing your income by not ratcheting up spending when your income spikes.. and consumption smoothing is good if you’re saving some of today’s income for tomorrow’s spending (e.g., for retirement).
I suppose this comes down to a definition of the phrase, “consumption smoothing”…
Is consumption smoothing similar to lifestyle creep then? I would argue for people in medical or law school they are, except that in medical school lifestyle creep comes in the form of people advising you to take out loans now because you will make lots of money later. Enjoy life now they say! You live only once! You don’t know what tomorrow brings!
These are the types of advice that get young people in trouble. Plus, you are absolutely right. Borrowing now is borrowing from future you and it is unlikely future you will agree with your choice!
I think most people would agree that consumption smoothing is a terrible idea when financed by debt, but there are subtler ways to do consumption smoothing that seem like reasonable financial planning. For us, we’re doing a bit of consumption smoothing by manipulating our savings rate. We (resident SO + highly-paid tech person) increased our spending* to buy a house but are still saving a lot** but not quite as much as I’d like. Our current expected savings rate wouldn’t be enough to meet my financial goals as quickly as I like, but if we keep spending roughly stable after residency, our long-term savings will be where I’d like. It seems like there’s a way to do sensible consumption smoothing when it’s part of a longer-term concrete financial plan (with real numbers and realistic assumptions).
* We increased our spending plans from about $3.5k/month to about $5k/month after buying a house.
** When deciding to buy a house, we were expecting a 35% savings rate, but with my bonus it ended up closer to 50-60%, which is what my goal would have been, so the whole thing is kind of moot, but it made it easier for me to commit to a house.
I hardly think you’re engaging in consumption smoothing with a 60% savings rate.
There will always be someone who spends more and has nicer toys/houses/cars/boats/clothes/shoes. Once I realized that I could never keep up, even with debt, it was easier to take the next step and realize that I didn’t want to keep up.
Even with a big raise, I don’t think our lifestyle would change. We’re happy with what we have and what we do, so we’d funnel the new $$ into savings until we were financially free then give away the rest.
I sort of wondered whether people going into medicine expect to have a healthy income that comes biweekly, so it becomes easy to consume their way into that lifestyle prior to getting that first paycheck.
In contrast, most people running their own business know how much fluctuation in sales are month to month. Do they practice consumption smoothing?
Frankly, I don’t think that consumption smoothing can possibly work. If I stayed at Ritz Carltons as a medical student thinking that I’d make up the difference as an attending, I’ll soon discover that there are Four Seasons or higher tier hotels. I’d sure as well move into those once I am making attending money.
I’m going to take a slightly contrarian position here. I agree that leasing luxury cars while a resident is foolish. However, for many people’s lifecycle the years of med school/residency/fellowship are the glory years before you “grow up” and settle down. I can think of memorable vacations, etc that I took in my 20s that I wouldn’t be able to take now. Had I played it straight and narrow and not splurged then I’d have missed out on some good times. The only other caveat was that back then was a little different time, less borrowing for loans, lower interest rates, so less of a hole to climb out of as an attending.
Everything in moderation.
There were definitely many classmates who lived very large in law school and my wife’s medschool, borrowing exorbitantly against their futures, sinking themselves deeply in debt, living like an attending while the interest accrued on their interest.
But I wouldn’t go back and undo the vacations and experiences that my wife and I had through school and even to today just to put a few more nickels away for retirement. If you wait to do anything remotely nice or excessive until you’re independently wealthy, then you end up becoming a lonely, elderly person. There’s no perfect time for anything. Pinching every penny and obsessing over your monthly statements for over half your life while you force you and your family to live in some spartan squalor to save up for “one day” is no way to live.
This post is similar to Dave Ramsey saying credit cards are bad. For the average American the result of credit cards and consumption smoothing is bad because they do not understand it properly. If you know to pay off credit cards properly, their convenience and rewards are awesome. Same for consumption smoothing. I would venture to guess you did some strong consumption smoothing when you took your military scholarship. You sacrificed “future you” with lower income right out of residency to enjoy stipends during medical school. I agree dramatic consumption smoothing (ie a straight horizontal line = same spending every year) is not advantageous and too costly. And I think this is the premise of your post. More reasonable consumption smoothing (ie a diagonal line = slight similar increases each year) is psychologically rewarding. How conservative the slope of the line or spending increases are is the very subjective personal debate. The absence of consumption smoothing (often a bell curve with exponential rise and exponential fall) is psychologically damaging. And most of the damage is done not during the fall but during the rise when priorities are easily skewed by one’s success. You seem in favor of saving dramatically (like the rest of the FIRE crowd) in hopes of making your spending curve be a horizontal line followed by an exponential curve. I don’t think this would be very satisfying for a long career. Maybe the Mustachian crowd of under 10 year career can make this work but I would argue it often requires extreme consumption smoothing. I think people need to have a real debate within themselves of what is “enough” in comparison to the sacrifices necessary to get there.
+1 great post. Just because many people can’t handle it doesn’t mean that it’s bad in general.
I agree in a sense. Consumption smoothing that forces you to work hard right up till you retire at 65 is not a good idea, but some consumption smoothing that still buys early financial security is not that big of a deal. Only issue I see is that lifestyle creep is a real thing. Adding consumptions smoothing to too much lifestyle creep equals no financial security, stress, and less happiness.
Reality is that no one answer fits every person/family. As long as the goals are reasonable, and the trajectory is lined up towards achieving those goals, then having lifestyle creep and consumption smoothing is equally reasonable.
The message of this is good but there’s a couple huge holes:
A home loan is the very epitome of “consumption smoothing.” But unless you can rent very cheaply, or have some need to rent, etc., it’s commonly accepted and even encouraged as responsible to purchase a reasonable home instead of throwing money away on rent. Generally speaking you can spend less money per month buying than renting, building equity as you go until eventually it’s paid off and you have negligible housing expenses.
A student loan also captures the very essence of consumption smoothing. Pay for your very expensive education over a long period of time. The only ways to avoid this are to 1) be born to wealthy parents who rain money on you or 2) don’t go to expensive school (all med school is expensive, some just more than others). You simply can’t pay your way through medschool, be it due to the rigors of school or due to the rules which often literally ban you from holding other employment outside of school.
You can argue that a home is “consumed” over the days, months, years you live in it (which it is), or that you “consume” your education over your professional career, and thus can justify paying for it over those periods, but then the same thing goes for a car loan and many other things you put on credit. You wear clothes and jewelry over several years, you use your phone everyday for a few years, you go hunting or fishing or golfing every so often…. The argument then just boils down to true one-time-use expenses like vacations, meals, entertainment, flowers, booze, disposable cameras 😉
Via Email from an MD/MBA:
Jim – I love you blog and love your philosophy. However, You are
giving consumption smoothing too bad a wrap. Consumption smoothing is
a tool one can use to achieve life goals. Like all tools, there might
be risk, but the tool often is essential to getting a job done.
Take a common and important episode in life which frequently arrives
coincident with finishing training – having a family.
Being able to set your life structure to enjoy being with your family
in a level of comfort counts, adds value, and cannot be reclaimed
later in life because kids grow up and leave. Having a house with a
mother-in-law for your extended family to visit, enough space so you
aren’t driving each other crazy, a vehicle that can move all parties
conveniently, being close to work to minimize commute time, using
higher cost grocery delivery to enable more family time not spent at
Safeway and Costco, a biweekly cleaning service, a membership at a
local CSA, etc. are all things that resident me would not consider.
However, those are all things that I have found well worth stretching
to achieve because there is a unique window with kids which is short,
closes, and cannot be re-captured.
I don’t believe you can sacrifice basics – 20% savings annually, life
and disability insurance for instance – and do believe that it is
important to define where you are consumption smoothing and where you
are being thrifty. For our family, we don’t buy nice clothes or take
expensive plane flights, no expensive jewerly, only basic tech
gadgets, restaurants are kid friendly and low cost, and craigslist for
most furniture. We use the minivan for vacations and shop at
consignment stores. That sounds like live like a resident ethos.
But we did get a car loan (I hope our last) to have a four wheel drive
minivan since we do lots of outdoor activities and got leather seats
since it moves the needle on kid clean up. We did buy a costly house
for the above-mentioned luxuries and invested more in re-model
upgrades. I do drive to ski areas and spend too much on lift tickets
and lessons and all the stuff that comes with ski families. (But we
will NEVER buy a cabin.) We have a swanky jogging stroller and bike
trailor because those things make my life better and are luxuries that
count personally.
I can easily justify those choices because I want to create a specific
family experience and if I wait until financial independence to
execute on those items then my kids will be in college. Consumption
smoothing is a tool to do that. Would I do it on margin? Well, yes – I
did it that way by taking car and house loans that are large. Am I
naive to suggest that not having money will result in less happiness –
no. Families are wonderful and generally create their own joy
irrespective of stuff, but let’s be honest – stuff helps. I’m in the
top 5% and grateful for that, but I also recognize that I’m investing
now in my family and for me, that is worth enduring less aggressive
home equity buy-downs or college savings.
With a two career family some of the “luxuries” buy sanity, save our
marriage, and free up space to cram more into life. That is a good use
of capital.
I would argue that debt to enable those behaviors but aligned with 20%
savings goals is debt that you can accept and for which it makes solid
life sense to do. Life has chapters. Family is one of them, and it
comes early.
Totally agree with WCI’s take on it. The biggest problem I see to this philosophy is that it assumes too much. It assumes you’ll be able to pay it all back and ignores the very real possibility that life can change and make all that debt a very big problem. I can attest to this personally because I realized 5 years into practice that I really didn’t enjoy my job and wanted a career change (like didn’t want to be a doctor anymore kind of career change). And I had not been careful about saving, paying off debt, or living frugally. Fortunately, I’ve been able to find work that is more satisfying and tolerable than my last job and will pay enough to keep things good, but the stress that this has caused me is immense. It is very psychologically damaging to see a big mound of debt and suddenly not feel secure about your income. I wouldn’t wish it on my worst enemy! Promoting the idea of “go ahead and borrow as much as you want now and pay for it later” is absolute stupidity in my opinion.
I thought taking fewer shifts before you are financial independent is a form of consumption smoothing. You consume more time off now instead of waiting to hit the holy grail and then call it quits.
Yea, it turns out the term consumption smoothing can be applied to a lot of things. I guess what I was really railing against was the idea of living like an attending while you were still a student/resident.
I have to agree with consumption smoothing crowd with certain items.
There are definite seasons in life when certain things are more likely to happen for most people. Take getting your education for one or even having kids for a second example. Chances are you are going to want to move out of that 2 bedroom apartment into a nice house that you can form those priceless family memories on Christmas morning with your 4 kids and a dog.. You are not going to wait to have kids in your 60’s when your finances are on autopilot
Could you live in that 2 bedroom condo? Sure, Been there, done that. Its a hell of a lot easier to get a mortgage and use leverage to my advantage than sitting on top of each other in 1000sq ft.
You also might need to buy that larger SUV or minivan to get them and their friends around to soccer practice etc… Does that mean you have to buy a fully loaded GMC Suburban Denali? Of course not, but its still going to cost a hell of lot more than your 10 year old Corolla you drove in medical school.
I think these are the good examples of consumption smoothing that they had in mind, I could be wrong, I hadn’t heard much about it until I read your post.
I highly doubt the intent of the consumption smoothing crowd is for me to take my family skiing in the Swiss Alps right now because I could borrow from my future self. Interesting topic for sure, thanks for bringing it up.
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Your examples would make sense except that an attending should easily be able to buy a minivan with cash and a nice house with a mortgage of less than 2X his gross income.
Having lived in the 1 bedroom condo, the two bedroom duplex, a three bedroom townhouse, and the current monstrosity where we cannot seem to keep all three floors clean at once, I can assure you that priceless family memories do not depend on the size of the house.
Your arguments/justifications are the same ones used by docs who get themselves into financial trouble. Be careful with them.
Stale post, but I’ll still chime in. I first encountered this notion while (briefly) studying Milton Friedman’s “Permanent Income Hypothesis” in the 80s as an undergrad. It provides a pretty compelling framework for at least some “consumption smoothing”– especially if you use some common sense and moderation. When you’re a starving student, the marginal utility of consumption can be very high. The extra $50 to see a show or $1000 to take a trip (or whatever) are opportunities that might be hard to replicate later in life, even if you have the money later (time becomes more valuable / you’re only young once, etc.). The risks are that you overestimate your future earnings and/or that your borrowing costs swamp the apparent NPV of the proposed spending item. But, for many people in competitive Law/MBA/MD programs (for example), their future earnings potential can be estimated with reasonable precision. In these unique situations, it is conceivable that, for example, carrying $5000 on a credit card for a year or two (even at 15% interest, or whatever) to fund a summer’s worth of travel could be a very smart way to increase your aggregate happiness over the course of your life. Leasing a $60K BMW versus driving a $20K Honda, probably not so much. For me, the key was to try to be honest with yourself about predicted future income and the liquidity/cost of capital implications.
Be careful, it’s a slippery slope. You’re right that a little probably doesn’t hurt much and a physician-level income can overcome a lot of financial mistakes. But I’ve met a lot of doctors that are very sad about their $400-600K loans.
Thanks for sharing! I believe you, and others, may be missing a key point about consumption smoothing. To correctly implement consumption smoothing requires that you accurately estimate your expected future earnings. Many people, including physicians, may be overly susceptible to optimism bias when it comes to estimating their future earnings. They may expect that they’ll receive a higher total compensation package than they actually do, or that they’ll be able to work longer without burning out. This is an important point. If I knew with absolute certainty that I was going to make $500k a year and would work for the next 30 years, I’m looking at total future earnings of $15M. If I knew that I was going to live for 60 years, consumption smoothing would tell me with absolute certainty that I could spend $250k a year before taxes ($15M/60). At that point, I’d go out and spend $250k a year and readjust each year if my projections changed. Now, in reality no one knows with absolute certainty how much and how long they will earn. It’s a guess. If we overestimate our lifetime earnings, we overestimate how much we can spend now, and vice versa. For me, I suspect that many physicians are simply overestimating their expected future earnings. Reduce those expectations and consumption smoothing gets you a lot closer to where you ought to be.
The problem is that we are happiest with a gradually rising standard of living, not a flat one. That’s the biggest issue with consumption smoothing.
Great article. I completely agree. I’m coming here after the podcast risk parity radio mentioned it. You should have him as a guest on your podcast