Behavioral Life Cycle Theory

There have been many economic theories developed in order to understand how and why human beings save and spend their resources. Up until now, most of these theories have been developed based on the principles of theoretical finance.

The first theory to be put up in this regard was developed by Modigliani in the year 1954. As time passed, Nobel Prize economist Milton Friedman also made certain advances in this theory. He devised a permanent income hypothesis.

This hypothesis postulated that all households are able to calculate the total wealth that they will accumulate in their working years.

Then, based on this assumption, they are able to derive the post-tax annuity value of what their total wealth will be. This post-tax annuity value is the amount of money that they end up spending every year. This hypothesis also came to be known as the life cycle theory.

However, even the life cycle theory did not take into account any aspects of behavioral finance. This was strange since the world now knew how profoundly behavioral finance impacted investor behavior.

It was, therefore, time to upgrade the life cycle theory. Hence, a new theory was developed, which included behavioral aspects into the life cycle theory.

This was called the behavioral life cycle theory. This article explains what behavioral life cycle theory is and how it impacts the savings decision.

What is Behavioral Life Cycle Theory?

The life cycle theory talks about the process of accumulating and decumulating assets throughout the lifetime. This theory divides the life cycle into certain stages.

1. At the first stage, individuals are decumulating assets because they spend more than they make. This is because they have to spend on education, starting a family, and so on.

2. Over the years, their income rises, and their expenses do not rise as much. Hence, they are able to save a huge chunk for retirement.

3. Finally, during the last stage, i.e., post-retirement, they try to utilize most of the savings that they have made in their earning years.

According to this theory, people only leave money behind since they are not able to predict the time of their death and hence have to be conservative with their spending.

Over the years, as financial theory started talking about different biases, it was realized that their impact should be included in the life cycle theory as well. This is the reason why the self-control bias, framing bias, and mental accounting bias have been included in the behavioral life cycle theory.

How Biases Impact the Life Cycle Theory?

• Self Control: Traditional financial theories seem to assume that investors have only one objective, i.e., to maximize their wealth in the long run. However, this is not true. The reality is quite the opposite.

  Human beings are constantly faced with temptation. Every day, people have to make choices wherein they can either choose immediate gratification, or alternatively they can delay the gratification and choose long term wellbeing. Any economic model which does not take this conflict into account is not a realistic model. The behavioral life cycle theory does take the self-control factor into account because the theory has been built to account for two sets of preferences that have been separated by a time period.

• Mental Accounting: Traditional financial theories operate on the principle of fungibility. This means that a dollar in one investment account is interchangeable with a dollar in another investment account. However, this is not the case in reality. Because of advances in behavioral study, we now know that households operate through a network of mental accounts.

  For instance, money in the retirement account is considered to be sacred and hence cannot be interchanged with money being used for everyday expenses. The behavioral life cycle model divides money into three distinct accounts, viz. currently spendable income, current assets, and future income. This is different from the traditional life cycle theory was considered to be fungible. The behavioral model tends to be more accurate since it is based on investor psychology and hence can predict the outcome better.

• Framing: The third bias, which is introduced in the life cycle theory, is called framing. This model basically states that people will alter their investment and saving behavior based on the manner in which the information is framed.

  The behavioral life cycle model postulates that the savings rate will be affected by the way in which the income is framed. For instance, if a person receives 25% of their income as a bonus, they are likely to save income. However, if the same 25% is received in monthly installments, they are more likely to spend the same in day to day expenses.

Critics of behavioral life cycle theory believe that this theory is incomplete since it does not take into account so many other biases that investors face. However, proponents of this theory believe that other biases are not as relevant to savings as they are to investing behavior. As a result, they are not considered.

The bottom line is that behavioral finance has started touching each and every aspect of financial theory. This includes theories that have been traditionally used to explain the phenomenon of the savings rate.