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"Save what you don't spend" and consumption smoothing

Last time I wrote, I talked about when month-to-month cash flow doesn't matter -- which may sound like dangerous personal finance heresy on the surface, but has a lot of merit when you dig deeper. So while we're preaching heresy, let's throw another little grenade: "you should save what you don't spend, rather than spending what you don't save".

I know, I know -- everyone from reddit to your most respected personal finance guru tells you to "pay yourself first", that your "savings rate" -- the percentage of your monthly income that isn't spent -- is the single most important metric in your financial life. And I understand the behavioral logic behind it...and, nonetheless, I disagree.

Because, as you've likely noticed in some of my other articles, I firmly believe that behavioral crutches, while useful when they're necessary, ultimately limit our ability to optimize our finances. Mindful financial planning can allow us to remove those crutches, and thus our improve our ability to live richly, rather than just die rich!

Consumption smoothing, and why it's relevant

If you read that article I linked above -- or you just like nerding out on microeconomics -- you may already know what consumption smoothing is. If not, here's a summary: the idea behind consumption smoothing is that you can best "maximize your utility" by targeting a consistent standard of living throughout your life, rather than living like a king one year and a pauper the next (or vice versa).

(Side note: what does "maximize utility" even mean? Simply put, I tend to think of it as "living richly", rather than "dying rich". And yes, living richly is much, much more than optimizing your finances...but this is a financial blog, so we're going to stick with the financial bits. For now.)

And why is it that consumption smoothing maximizes utility? I mean, doesn't Dave Ramsey say that "if you will live like no one else, later you can live like no one else"? Aren't you supposed to put away money like crazy, so that later on you can Be Free?

Sure, that sounds nice -- and perhaps more importantly, it can be the necessary motivating factor when you're up to your eyeballs in debt. But economists have spent a lot of time studying what brings people utility, and what they've found is that there's a consistent pattern of diminishing returns: the more you get of something, the less you value it. At this point, you probably remember now that the fifth slice of pizza, or donut, or whatever it is your high school econ teacher used in the object lesson they gave you, is much less enjoyable than the first!

Most of life is like this -- travel is like this. Fancy cars are like this. Nice homes are like this. And yes, for those of you in the frugal FIRE movement: free time is also like this. (So if you take nothing else away from this, take this: if you think that living richly means retiring as soon as reasonably possible so you can drink margaritas on a beach somewhere, you are probably wrong. I literally spoke with someone just last week who'd tried the experiment during a DIY sabbatical, and they were booooooored! )

(though it's not just about smoothing)

Having said that: consumption smoothing is not the end-all and be-all of optimizing utility. There are other factors to consider!

For example: when you spend can have as much effect on your utility as how much you spend! If I spend $50K on travel in 50 years (inflation-adjusted), will I enjoy it as much as spending $50K now? Ignoring the fact that I'll likely be dead, even if I'm not, I won't have nearly as much energy and focus as I do now. Moreover, if I take the trip now, I can savor the memories for the next 50 years; if I wait 50 years, I won't have quite so many left!

A car with all the safety features won't be terribly important to me in 5 years...but right now, when both of my sons are learning to drive? It's vital.

And my wife and I pulled out the stops for our wedding a few months ago, spending more than felt natural for us. But we knew that this would only happen once, and that it wouldn't break our financial plan, and we focused on spending only on the things that mattered deeply to us.

Why a consistent savings rate doesn't optimize utility

(You're smart, so I probably don't need to even write this section, but I'm going to anyway, in case you're half-distracted by something else. )

I've said that consumption smoothing is good, and you should be mindful of your "utility", but why does this make a consistent savings rate bad?

Simply put: because if you're focused on your savings, you're only indirectly focusing on your spending, and your spending is what's actually important!

And if your income is lumpy -- which for most of our RSU- and bonus-compensated clients -- then that exacerbates the issue. If you focus on your savings rate, in lean times your spending is lean, and in rich times your spending is rich, oscillating all around and completely blowing up your utility. Not only do you suffer from diminishing returns in the rich times, but prospect theory reminds us that we hate losing things more than we enjoy getting the poor times are that much more painful!

In short, it's better to have as steady a standard of living as possible -- keeping your spending rate constant and letting your savings rate oscillate -- than the alternative, from a utility-maximization perspective.

How do shift focus from savings rate

The advantage of a consistent savings rate, of course, is that it's easy. And for most people, the object is to remove as many barriers as possible. "Maximize your savings rate, and you won't get into trouble." Which is absolutely true...but if you're reading this blog, you're generally less worried about "getting into trouble" and more worried about, well, optimizing utility, even if those aren't the words you use!

In this case, the objective is to maximize utility over your entire life -- to figure out what to spend when, and to balance that against retirement, college savings, and other major milestones. This is, in fact, what a financial plan based on cash flow projections allows you to do: "If I spend X much per year on average, including Y major milestones (college, new house, wedding, etc.), when can I retire?" Alternatively, "if I want to retire at year t, including the aforementioned major milestones, how much is my sustainable baseline spend?"

Of course, it is vital that such a plan is adaptive, because "always in motion is the future"! Your portfolio will wax and wane with the economic tide; your income will vary based on your professional track (and this is what your primary financial focus is, yes?); your expenses will come in lower or higher (generally higher) than you anticipated.

Heck, what you value will change over time -- like the wise person I mentioned earlier, you may have thought early retirement was the bees knees, but then decided otherwise after your DIY sabbatical!

Therefore, it's important to periodically check in and course correct, and to maintain liquidity, even beyond cash to serve as a buffer in case said changes happen quickly!

(And if all this was helpful but left you with more questions than answers, you know where to find us!)

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.

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