Behavioral life-cycle models
Behavioral life-cycle models are a consumption and savings approach proposed under behavioral finance. These models are part of behavioral finance, a field within finance that challenges traditional finance notions. One of the alternative behavioral finance models that is proposed is the consumptions and savings approach.
On this page, we discuss the behavioral life-cycle model proposed by Shefrin and Thaler in 1988 in a paper titled “The Behavioral Life-Cycle Hypothesis”. We contrast it to how traditional finance assumes investors save and invest.
Traditional finance view
Traditional finance assumes investors are able to save and invest in the early stages of their life to fund retirement. This means that investors should be able to show self-control by delaying short-term gratification to meet long-term goals. While people do save, behavioral finance argues that people exhibit biases when they save money.
Behavioral life-cycle model definition
The behavioral life-cycle model assets that people will exhibit behavioral biases. In particular, they will probably show mental accounting and framing biases. Investors will mentally account. They will frame wealth as current income, assets currently own and present value of future income.
Traditional finance assumes that individuals treat all forms of wealth interchangeably. Behavioral finance argues that mental accounting for wealth by source causes makes people less likely to spend from current assets and expected future wages but more likely to spend from current income. Thus, part of the lack of self-control in individuals will be remedied by this mental accounting.
Framing bias is also relevant here. People will be more likely to spend a bonus if they perceive it as current income. They will be more likely to save it when they perceive it as future income.
Summary
We discussed an alternative theory of how people save and consume. Rather than saving and investing in a rational way, people are more likely to exhibit behavioral biases. This causes them to treat different sources of wealth differently, when making consumption and saving decisions.