In finance theory, it’s usually assumed that people care not just about how much wealth they have, but about how much their wealth is likely to fluctuate year to year. For example, many finance professors will teach the concept of mean-variance utility, meaning that people weigh the amount their bank account goes up on average with the amount that it randomly bounces around.
This partly explains why risk is bad. At some point, you’ll have to take money out of your account. Maybe you’ll need to pay for something, like your son’s wedding, or your daughter’s college education, or a big medical bill. If nothing else, you’ll eventually retire and have to sell at least some of your investments. In other words, risk is bad because of liquidity needs — those incidents of life that force you to cash out.
If risk is scary for the rich, think how much more terrifying it is for the poor. The kind of event
that causes a low-income American to suddenly need money isn’t a wedding or college or a comfy retirement — it’s coping with an eviction, or getting robbed, or a broken pipe in their house, or their car breaking down. The life of a poor American is a nonstop sequence of sudden disasters and looming threats. If you don’t understand this, read “Evicted: Poverty and Profit in the American City” by Matthew Desmond. For a middle-class American, the situation is less awful, but big medical bills and other surprise expenses are still a very significant risk, and many Americans have little savings in the bank to cushion the blows life throws at them.
Given the risks of life in America, and the paucity of savings, a consistent income is very important. The more you live paycheck to paycheck, the more you need to be sure that the paychecks won’t stop coming — and that their size will be relatively constant from month to month and year to year. Unfortunately, during the past 40 years, income volatility has risen for the average American.
Many studies have documented rising income volatility. A new paper by economists Robert Moffitt and Sisi Zhang reviews these studies, and presents updated results through 2014. Their finding confirms that U.S. income volatility rose in the late 1970s and early 1980s, plateaued from the mid-’80s through the late 1990s, and then began to rise again:
Moffitt and Zhang also create a mathematical model to separate income volatility into short-term (“transitory”) and long-term (“permanent”) income components. They find that both components have become much more volatile. The increased variation in long-term income is particularly worrying, since it means that American workers are suffering an increased number of unpredictable changes in the long-term trajectories of their careers.