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Consumption Smoothing

Posted By: 06-18-2007 11:38 AM by scottb. 1 replies.
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  • 06-18-2007 11:37 AM

    Consumption Smoothing

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    I could not agree with you more regarding the degree of malpractice that exists within our industry.  You used a term in an article in Investment news called consumptions smoothing.  Can you give me a clear definition of consumptions smoothing?  FFP Wealth Management provides cash flow centered financial planning and investment management for our clients.  Our process may mirror your concept very closely.

    Sincerely,
    Roger

    posted from email 

  • 06-18-2007 11:38 AM replied on

    • scottb
    • Top 10 Contributor
    • Joined on 05-18-2007
    • Austin, Texas
    • Posts 1,541

    Re: Consumption Smoothing

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    Roger,

    Consumption smoothing, as an idea, has a long history in economics. The late Franco Modigliani won a Nobel for his work on life cycle saving theory in the 60s and it has developed quite a bit since. It is the idea that we all try to “smooth” our consumption over our lifetime, extracting the maximum utility. It means that we don’t squander our youth to benefit our old age, or squander our money when young to impoverish our old age.

    The idea has been easier to theorize about than put in practice until recent advances in computer power. Today, using dynamic programming, it is possible to enter a large amount of defining data and have a laptop prescribe what your lifetime consumption should be, year by year.

    This is different from common financial planning practice in which a series of problems are attacked as saving/investment issues without treating their interrelationship, how they impact our taxes, etc. So conventional  planning generally makes guesses and is generally wrong.

    There is a section on consumption smoothing on my website. And next year there will be a book--- Simon & Shuster is publishing “Spend Till the End” next April, which I coauthored with economist Larry Kotlikoff. You can learn more about the idea and  his software by downloading the manual for ESPlanner from his website, www.esplanner.com. I’ve been interested in this since my first book on personal finance, published back in 1972 but the brainpower here is Kotlikoff’s, not mine.
                  
    As an idea, I liken this to the addition of monte carlo simulations to financial planning. When I took Peter Lynch to task for using determinist rather than stochastic analysis to tell the general public they could invest 100 percent in stocks and withdraw 7 percent a year, the vast majority in the planning community was making the same misleading error. That was 12 years ago.  Only a handful of planners--- like Bill Bengen--- took a probabilistic approach. I think much the same will happen with consumption smoothing: And it will probably take at least a decade for it to be added to the Accepted Tools in the financial planning toolkit.

    Scott
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