1.1. Life Cycle model of personal finance

Objective:
+ Identify likely paths for income and expenditures through life
+ Identify periods of saving, and dis-saving
+ See the need to borrow and save
+ Realize some events are predictable, others are not
+ Anticipate retirement, and end-of-life needs

Lecture  What is the “life-cycle model of personal finance”?

Many things have life cycles: butterflies, iPads, and, of course, humans. Our focus here is on the economic or financial life of a human, rather than the biological one described in that somewhat weird video. Our economic lives can be characterized by five very broad stages: child (birth), school, work, retirement, and legacy (death). We will focus on the middle three: school, work and retirement.

Watch video presenting the Life Cycle Model of Personal Finance

Notes to accompany the video (can be reviewed after viewing the video.)
1.1 Axes –
+ Horizontal axis indicates time, in years
+ Vertical axis indicates dollars each year of earnings and spending
1.2 Important “dates” –
+ Graduate from school/college, G
+ Retire from work, R
+ End of Life, E
1.3 Earnings each year (shown by green line)
Events include first job after school/college (at G)
Promotions and changes in jobs for higher pay
Earnings from work drop to zero after retirement, at R (by definition)
1.4 Spending each year (shown by red line)
Some events are predictable: car, house, vacations, children to college
Some events are unpredictable: accidents (disasters,) repairs, medical
Spending continues after retirement, R, especially medical near E
1.5 Net earnings are earnings less spending each year (shown in blue)
+ Generally follow negative (àG), positive (G à R) then negative (àE)
1.6 Identify life stages:
I – School. Investing in human capital (Dis-saving)
II – Work. Build and maintain more human capital (Saving)
III – Retire. Gifting (Dis-saving)

Conclusions drawn from Life Cycle Model (read this after watching the video):
a) The life stages are very general, and critical dates (G, R, E) vary for each person
b) Because the dates vary, the length of each stage varies person to person.
c) The path of earnings (shape of green line) is determined by many factors and events. These events are of two general types:
–Predictable (controllable,) such as occupation, changing jobs, decline promotion.
–Unpredictable, including being laid off or fired, moving locations and jobs for family reasons.
d) The path of spending (shape of red line) is also determined by many factors, which fall into two broad categories:
–Predictable (controllable,) such as buying a house, sending children to college, going on vacations.
–Unpredictable, including accidents, repairs, medical spending.
e) Net earnings each year (shown by the blue line) has a general pattern of negative, then positive, then negative.
f) Earning and spending will rarely match in any year.
g) People need a way of moving earnings to better match spending over time.

So we get to the Main Point — People need the means to move money or wealth across time. The most effective ways involve financial assets and markets.

The rest of Economics 212 is about those financial assets, and how they are used to move money and wealth across time to achieve each person’s, and each family’s lifetime goals.

Take the Quiz on the Learn website.

Aside: A note on Life Cycle Investing
This lecture is about the Life Cycle model of personal finance, but there is also a book called “Lifecycle Investing” by Ian Ayres and Barry Nalebuff, which proposes an investment strategy based on the life cycle model. A general description of the strategy is provided at the Social Security Administration website link:
http://www.ssa.gov/policy/docs/policybriefs/pb2007-02.html
The strategy does have its detractors, though: http://seekingalpha.com/article/857601-lifecycle-investing-good-in-theory-bad-in-practice

Aside: A note on Saving (not specifically for retirement, see Homework)
Americans are notoriously poor savers. See this article from The Economist:
http://www.economist.com/blogs/freeexchange/2013/04/saving

Resources/links
1. Additional information to support the lecture. Paper by Bodie, Z, Treussard, J and Willen, P. “The Theory of Life Cycle Saving and Investing” Note, this paper is somewhat technical, and I would not expect you to comprehend all of it. However, I encourage you to read it, skipping over the bits that don’t make much sense, and find the parts that you can understand. There are enough of them to make the paper worth reading.
2. SSA article on Lifecycle Investing: http://www.ssa.gov/policy/docs/policybriefs/pb2007-02.html
3. Article criticizing Lifecycle Investing:
http://seekingalpha.com/article/857601-lifecycle-investing-good-in-theory-bad-in-practice
4. Article about savings in the US from The Economist:
http://www.economist.com/blogs/freeexchange/2013/04/saving