Overspend Now, Pay Later
Consumption smoothing is the idea is that when you’re younger and make less money, you spend beyond your means. When you’re older and you make more money, you make up for it by saving. Whether or not they know it, this theory is practiced by many, as evidenced by the widespread increase in college loans. These loans represent spending beyond one’s means.
But for recent graduates that adhere to this economic theory, I want to present to you a critical downside of this model. I was recently discussing retirement savings with a friend who graduated college 10 years ago. He said that he had about $25,000 saved in his 401(k), not bad for someone with a $50,000-per-year income, but below where I thought he should be. When I inquired as to how he arrived at this amount of savings, he relayed a story about consumption smoothing gone wrong.
When he first graduated, he took the summer off and racked up about $4,000 in credit-card debt. When he started work he built up an additional $4,000 credit-card balance by the end of his second year after college. He justified his overspending with the consumption smoothing narrative (“I’ll make more later”).
Thankfully, he righted the ship and paid $400 per month until the debt was gone. He started paying off his debts in January 2007 and the burden was fully lifted by December 2008. This was six years ago, and he hadn’t thought much about it since.
I ran an analysis of what $400 per month saved from January 2007 through December 2008 would be worth today had he invested in a broad market index (I used the Russell 1000 for the example), instead of paying down his balance. His savings would have been about $18,000 higher today. If we extrapolate this into the future at a 5 percent growth rate, he could have had more than $75,000 by the time he presumably retired after 30 years.
Recent graduates should heed this warning: Today’s financial decisions affect tomorrow’s financial outcomes.