Reviewed by Jan 29, 2021| Updated on
Consumption smoothing refers to a process of achieving a balance between spending for today's needs and saving for the future. The aim is to balance out spending and saving during the different phases of life. It is a major financial planning challenge for anyone to achieve this balance.
The concept focuses on saving while earning in a balanced way. It focuses on achieving a balance between the standard of living for today and the standard of living after retirement.
A person's spending requirements are based on their needs and desires, while savings are meant for retirement years. Consumption smoothing requires an understanding of the spending and saving requirements of an individual.
Consumption smoothing is a concept based on human psychology and behavioural economics. As an economics concept, consumption smoothing tries to capture the desire of people to have a stable path of consumption.
It involves the study of present consumption patterns and savings patterns of individuals. Consumption smoothing is a continuous process adapting to the changing income levels, spending patterns, and retirement goals.
A person who overspends today and puts off saving for retirement to enjoy a higher standard of living are likely to work longer and/or reduce their standard of living in retirement. A person who saves today will live a more frugal lifestyle while working to enjoy a better lifestyle after retirement.
Consumption smoothing has 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 laws, or unforeseen tragic events (loss of a member of the household), it's even harder to predict future consumption patterns.
A person may be faced with a lot of data and issues which could pose practical challenges. Accordingly, consumption smoothing focuses on continuously adapting and refining its methodologies to meet the changing nature of spending patterns.