What is 'Consumption Smoothing'

Consumption smoothing tries to describe the ways in which people try to optimize their lifetime standard of living by ensuring a proper balance of spending and saving during the different phases of their life.

Those who overspend and put off saving for retirement to enjoy a higher standard of living often have to work longer or reduce their standard of living in retirement. Those who over save will live a more frugal lifestyle while working to enjoy a better lifestyle while retired. In each case, the overall standard of living is less than optimal.

BREAKING DOWN 'Consumption Smoothing'

Saving for retirement is a delicate balancing act. By having a better understanding of the saving and spending requirements to smooth out the standard of living, one can have a higher overall standard of living, at least in theory. But this is easier said than done, and striking this balance is one of the major challenges of financial planning.

As an economics concept, consumption smoothing captures the desire of people to have a stable path of consumption. This invites a number of related areas of study, such as behavioral economics, psychology and even anthropology.

Humans dislike and go to great lengths to eliminate uncertainty in their day to day lives. Consumption smoothing is an economics attempt to identify how they go about this, from the angle of consumption (spending) patterns.

Consumption smoothing has some validity in the short-run, but the long-term predictive value is mixed. Because it is hard to anticipate future events, such as a change in income (be it a raise or loss of employment), the tax code or unforeseen tragic events (loss of a loved one), it's even harder to predict future consumption patterns.

It is common to take mental shortcuts, especially when faced with a lot of data, which makes anticipating their next moves challenging. As a model of consumption desire, consumption smoothing continues to adapt and refine its methodologies to meet the changing nature of spending patterns. For instance, since the early 80s, Americans have steadily increased healthcare spending as a percentage of GDP, while consumption of food-related items has remained flat, relatively. Consumption smoothing would seek to describe these changes in spending in economic terms.

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