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CTreit
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personal finance
Spend now, save money later. Finance Theory versus Personal Finance Bloggers
June 29th, 2010A few famous economists proposed the life cycle income hypothesis – it’s that people design their spending around the income they earn during their lifetimes. That is, economists believe that people behave as if they figure out how much it would be if they had in their hands today the total amount of income they’ll earn over all the years they live (also called the present value of their life’s income) and each year they spend the percentage that is the equivalent of one year’s worth of all that money. This thinking explains why young people do not save money but incur debt instead – they expect higher incomes later in life, and expect to pay back the debt then. It makes perfect rational sense, right? Yeah, maybe – but how many young graduates are drowning in student loans with this strategy? I mean, it’s just a theory! It’s not reality, and certainly it’s not reality for everyone!
This theory also (presumably) explains why people save money during their working years. They need some funds when they retire – that will be their income when they stop working. However, savings is a sticky point with the life cycle hypothesis, for a couple of reasons. First, why bother to save if your income is constantly going up? Second, the data about saving concludes that we’re actually not even saving enough! Three out of four Americans have under-funded retirement savings. I guess Americans have not yet gotten the memo about the life cycle hypothesis – they are stuck in the excessive spending pattern!
So, maybe, just maybe this hypothesis is not right after all. Well it’s sensible to think that people don’t work this way. First, think about the calculations that are involved in figuring out the present value of future income streams. Who can even assign a good enough number to his or her income 20 years down the road, forget about every single point in the future? Who can tell what discount rate or interest rate you should use when you want to know what the income 20 years from now is actually worth in today’s dollars? How about what estimate one should use to figure out how long you’ll live? If you end up putting funny numbers into your calculations, your result will necessarily be a funny number and not very reliable. Do you know the mathematical “rule” that says “garbage in(to an equation), garbage out”?
Economists are used to working with such formulas and applying them to human behavior, so they are not very bothered by a problem like this one. They assume that we behave as if we knew the discounted value of our future income even if we don’t know the actual number. For the sake of argument, let’s go along with this assumption, no matter how far fetched it is. Imagine you somehow know that the present value of your average income is $60,000 even when you are making $45,000 right now. Somebody tells you that it is okay to think of yourself as somebody who makes $60,000, because you will, eventually. So, let’s say you are “prudent” – that means you “save” 10% of your average income, or $6,000 and you spend the rest ($54,000). It also means that today, you will be short $9,000 considering your current income $45,000. You obviously have not saved anything. You incurred debt. And since you only actually make $45,000, it’s not going to be easy to pay that off. I mean, that’s one fifth of your income! And if you behave that way every year until you actually make $60,000 or more, you will certainly end up in deep financial troubles. So much for us behaving as if we knew the present value of our life’s income.
I find it amazing that a theory like that became prominent enough that I had to study it in school decades after it was proposed. I remember when the professor was talking about this hypothesis in all seriousness way before I knew anything about personal finances. It was ludicrous to me. My wife, who also has a graduate degree in economics, after a lecture about another theory once exclaimed to her professor, “But you can’t possibly really believe that people actually behave this way!” The professor said, “No, but it doesn’t matter. Economists believe that if these theories well enough approximate how people behave, it’s good enough, whether or not people actually think this way.”
This kind of thinking makes me question other expert advice or opinion, which may very well be based on theories like this life cycle hypothesis. Maybe the experts don’t know so much – maybe the people struggling day to day, just like we are, are the ones who know more. Like personal finance bloggers who are themselves trying to make good decisions without academic theories to guide them!
Okay, I’m going to end here because I now must go and read a few posts from my favorite personal finance bloggers…..
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“Maybe the experts don’t know so much – maybe the people struggling day to day, just like we are, are the ones who know more.”
I agree with this statement completely. Often times, people who claim to be experts have a lot of degrees and theories, but they don’t have any specific practical experience or suceess in their field. These so called experts tend to be authors and/or work in academia. This is true both for economists and for people involved with personal finance.
The good news is that personal finance is considerably less ambiguous than economics. It can be summed up with the single universal truth that people should spend less than they earn and invest the rest. Anyone who has a different theory is probably broke and/or trying to sell a book.
Great comment. I agree. The success of personal finance is based on these two rules. The only challenge is implementing then. — If you ever come across a statistic which supports your suspicion that people with a different theory are either broke or they are trying to sell a book, please let me know. I’d also love to call them out on this!