Smooth Moves

A great read, be sure and read the full article at the link below.

Some keen insights on saving, spending and our behavior.

Smooth Moves Greg Spears  |  Jun 8, 2022

WHEN I ASKED MY college class this spring how many had been taught personal finance before, just a single hand went up. That’s why I teach Franco Modigliani’s lifecycle hypothesis of savings to my behavioral economics class. A brilliant student born to a Jewish family in Rome, Modigliani was awarded first prize in a national economics contest by Mussolini himself.

Warned to flee Italy while he still could, Modigliani soon after booked a zig-zagging trip through Switzerland and France before landing in New York in 1939. He earned a PhD in economics at The New School for Social Research, then took a job at the University of Illinois.

During a long drive back from a conference on saving, Modigliani hit on the theory that would make his name. He reasoned that people would gain the greatest utility, or satisfaction, if their spending was stable or rose slightly over their lifetime. A drop in spending was unsettling and risky—as Modigliani had experienced as a refugee, when he was forced to sell books to make the rent.

Given this goal of steady spending, Modigliani thought the best approach to our financial life would be to save a fixed percentage of pay from the first day at work until retirement. Then we’d steadily draw down our savings, spending at the same rate we’d consumed during our working years. “Far from acquiring wealth as an end in itself, the role of savings was to accumulate resources to spend later on,” Modigliani wrote in his autobiography, Adventures of an Economist.

Invoking the story of Joseph in the Bible, Modigliani wrote that we should save “during periods of fat cows in order to transfer and consume them during periods of lean cows, with the aim of maintaining a stable average consumption over the course of one’s life.”

This might sound obvious today, but at the time Modigliani’s hypothesis suggested that saving should be a mass movement, not just something practiced by the wealthy with surplus income. This helped spur the creation of broad-based savings programs, such as IRAs and 401(k)s.

For this and other work, Modigliani was awarded the Nobel Memorial Prize in Economics in 1985. I tell my students that Modigliani’s approach to saving is the correct way to lead their financial life. But it also highlights how much economics has changed in the past half-century. Even though it’s the rational approach, it’s not the path most of us follow.

In actual practice, Modigliani’s hypothesis has four or five problems we struggle to solve.

First, it assumes everyone has the willpower to save continuously. Some people never get the memo, and most of us don’t save in our 20s. We have more urgent priorities, like getting out to bars, finding a decent apartment and laying hands on a dependable car. If you lack these, you may never get a date—the paramount goal at that age. Retirement? Forget about it. That’s a lifetime away.

This leads directly to the second problem—we overvalue the present and discount the future. If you get “hangry” waiting 10 minutes for dinner, you know how today’s needs dominate. By comparison, the groceries we’ll need for a month of dinners in 20 years have zero importance to us.

Source: Smooth Moves – HumbleDollar