Consumption smoothing is stupid Passive income M.D.
Consumer smoothing uses debts and savings to ensure a constant level of spending throughout your life. The White Coat Investor says it's a bad idea. Do not do it.
Today's classic is published by new White Coat Investor. You can see the original Here.
Consumption smoothing is the idea that your spending or consumption should be relatively similar throughout your life. That is, if you make a lot of money, you only spend a small portion of it, and if you don't make a lot of money, you borrow or use your savings to fund consumption.
At first glance, it seems wise – you can always spend the same amount of money, but in practice it's a really bad idea. I'm not the only one who believes that, and my review (which was actually written months after this post) from Jonathan Clement's book How to Think About Money (with a foreword by Bill Bernstein) showed me that at least two other bright minds agree with me. Dr. Amber said the following:
Academics praise the flood of so-called consumer smoothing: when you are young, you borrow a lot of money and then pay off this debt when you are old, in order to maintain your standard of living throughout your life. This is a really, really stupid idea as it ignores the habit: get used to the Beemer and Business class when you are young and if you are middle-aged you will need a Bentley and a private jet. My medical colleague and finance author Jim Dahle advises newly founded doctors to live like a resident for a few more years after starting their practice. That's good advice for almost everyone: get used to Motel 6 when you're young, and when you're older and richer, pinch yourself every time you check in at the Radisson.
Later in this book, Clements says the following on the subject:
This is about the so-called hedonic treadmill or the hedonic adjustment. The thought: We are aiming for the next promotion and are initially enthusiastic when the promotion is complete. But all too quickly we adapt to our improved circumstances, take the new job for granted and soon long for something else … The process of striving for material improvements and quickly adapting to these improvements makes it difficult to achieve a permanent increase of our happiness level.
If you look around, you will see examples of consumption smoothing everywhere. It manifests itself in medical students on vacation, paid for by student loans, residents driving cars that they can only afford after ten years, and new visitors who buy a house with zero down despite a net worth of -. $ 400,000.
There are obviously some valid uses of debt (consider how student loans can increase your career income five times if you had never attended medical school). In addition, savings in times of job loss, financial strain and certainly retirement are extremely useful. Despite these facts, smoothing consumption is a terrible idea for three reasons.
# 1 Consumer smoothing upset your mindset
A certain mindset is required to get rich / wealthy / comfortable, etc. Almost every self-made millionaire shares the same characteristics and mindsets. They work hard, save money and practice frugality, especially at a young age.
Consumer smoothing encourages you to never really develop this mindset. Like the little red devil on your left shoulder, he tells you: "Buy this Mercedes, you are a doctor and you will make a lot of money at some point." You deserve it."
It is unlikely that someone with a smoothed-out mindset instead of a wealth-building mindset will ever build the wealth that would actually enable consumer smoothing.
# 2 Expenses are like narcotics
More importantly, as mentioned by Bernstein and Clements above, the main problem in smoothing consumption is hedonic adjustment. If you live like a resident (you know to stay at the Radisson) there will be no reward for all your hard work later.
Spending and consumption are like narcotics. Not only can you become addicted to them, but you will gradually become tolerant so that the same amount of expenses no longer brings the same level of happiness. So if you spend the same amount all your life, your happiness, at least as far as it can be bought with money, will actually decrease due to this increasing tolerance.
Do you want to “smooth happiness” all your life? Then set up your finances so that you can spend a little more each year. That said, you should start spending very little early, which is exactly the opposite of consumer smoothing.
# 3 Consumer smoothing encourages you to borrow too much
Another big problem with smoothing out consumption is that a lot of credit is needed at least in the beginning and you then spend the rest of your life repaying those debts from your youth. Some people are big fans of debt and hardly distinguish between good and bad debt. Others are rabid against debt because "the borrower is the lender's slave."
I am more of a "debt is a necessary evil" that I can justify some debts, but they should be rare and far apart on the best possible terms and pay off relatively quickly, unless there is an obviously better use for the money (like getting the match in a 401 (k) or maybe maximizing the retirement account.)
The problem with debt is that it traps you in a path. If you borrow $ 450,000 to go to the medical school, guess what you will be doing over the next 20 years, whether you like it or not. That's fine if that's what you want, but too often it's not.
In reality, you don't borrow from the bank or the federal government. You borrow "Future You". And the future You may not estimate the amount borrowed or the terms that you have agreed to. You should assume that Future You wants to have a better vacation than you want, drive an even nicer car than you drive and have less financial worries than you.
Life also changes. You may want to change your career. You may be disabled, divorced, or widowed. Maybe you have a child with special needs. Perhaps your expected income will be halved. In all of these situations, the target level of expenditure for which you are “consumer smoothing” is too high. What now? You're hosed, that's something.
Thanks to the adjustment, we can easily adjust our lifestyle to a lower level and are still happy in the event of an economic downturn. However, if you have high debts and high fixed costs, this adjustment is difficult, if not impossible.
Smoothing consumption is a bad idea. People are not machines and life changes. Start your adult life with very economical habits and you will always feel rich.
What do you think? Do you believe in consumer smoothing? Why or why not? Why are doctors and other high-income professionals involved in this? Comment below!