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For centuries, economists have worked toward solving personal financial problems of households.
But how exactly can the concepts of economics be applied to financial planning?
Find out in this episode as Jeremy Keil speaks with Dr. Laurence Kotlikoff, professor of economics at Boston University and founder of MaxiFi Planner, a leading personal financial planning software. Dr. Kotlikoff dives into the benefits of economic-based financial planning.
Dr. Kotlikoff discusses:
- The inspiration behind his latest book: Money Magic
- Less risky pathways to improve your standard of living
- Consumption smoothing, upside investing, and other concepts to improve your finances
- Why it’s important to price every major lifestyle decision
- And more
An Economist’s Secrets to More Money, Less Risk, and a Better Life
Consumption Smoothing
Finding the right balance between spending and saving throughout your life is essential to achieving a higher standard of living.
With consumption smoothing, you won’t end up splurging today and starving tomorrow (or vice versa).
You might see this concept in financial planning when you buy insurance. By spending some money now, you’re ensuring that the bad times won’t be so bad at a later stage in life.
MaxiFi®, a financial planning software, was founded by Dr. Laurence Kotlikoff as a tool to project your finances and implement consumption smoothing.
Lifetime Budget
It’s also important to make sure your standard of living is within your reach.
That’s where the lifetime budget comes into play.
Everyone has a lifetime budget, and your spending can’t exceed it.
When Dr. Kotlikoff programmed MaxiFi® to perform consumption smoothing, it also accounts for your lifetime budget and provides a recommended spending amount accordingly.
Upside Investing
Now that you know how to have a stable standard of living, the next question is: How do you raise it?
Dr. Kotlikoff calls it upside investing.
Here’s a quick analogy to help you understand what it means:
Let’s say you visit a casino in Vegas. Before going to the casino, you left your wallet back at the hotel and only carried a few hundred dollars to use for gambling.
Next, you end up winning some money. BUT, you don’t spend it until you’ve left the casino. Once you leave the casino, you use your winnings to improve your standard of living.
In this analogy,
- The casino = stock market
- Your wallet at the hotel = your money outside of the stock markets (perhaps in safer investments like inflation-indexed bonds)
- Money used in the casino = money invested in the stock markets
- Your casino winnings = your stock market returns
When calculating your minimum standard of living, you don’t include the stock money until it’s out of the markets, which is equivalent to not spending your money until you leave the casino.
Every time you withdraw from the markets and invest the money into something safer, you’re increasing your standard of living. So, this is a floor to your living standard with an upside.
If you put more in the market, you’ll have a lower floor, but a higher upside. If you put less in the market, you have a higher floor, but a lower upside.
The money is also less likely to be withdrawn at the wrong time if it remains in the stock market for a long time (maybe until 65 or 70 years old). Essentially, you’re reducing your sequence of return risk.
If you invested in stocks at 40 and let it grow until 65, you’ll face zero sequence of return risk from 40 to 65. It doesn’t matter whether you get a high return today and a low return tomorrow or vice versa, you’re going to end up with the same amount of money at 65.
So, upside investing can help you raise your standard of living with less risk.
Pricing Lifestyle Decisions
A major decision can easily be clouded by emotions when you’re about to make it (retirement, divorce, having a child, etc.).
However, it’s important to think of these decisions in financial terms.
Imagine you walk into a grocery store where the items are placed without price labels. You blindly fill your cart. You’ll likely end up spending more than you wanted to! You can’t make informed decisions.
It makes you uncomfortable, right?
Making major lifestyle decisions without considering their financial implications is similar. You might not make the best decisions for yourself.
Ask questions like: If I retire early, will my standard of living drop by 5% or 20%? If I get divorced, to what extent will it increase my living costs? If I take an expensive cruise trip next year, how will that affect my future standard of living?
These calculations might be too complex to do in your head or on a basic Excel spreadsheet. Consider using a financial planning software like MaxiFi®.
Related: 7 Principles of Financial Serenity