FIRE: A Behavioral Perspective

If you haven’t heard about it already, there’s an increasingly popular lifestyle movement with a compelling proposition: live frugally, invest wisely, and gain financial freedom. It’s called FIRE (financial independence, retire early). The idea is popular among young people (particularly millennials) with decent incomes who wish to gain greater financial freedom early in life, ideally by retiring long before they reach their 60s.

A recent survey of an online FIRE community tells us a bit more about the demographic characteristics of the people who are attracted to this philosophy. Data show that they tend to be college educated, mainly in their 20s, rarely self-employed, and have a median annual household income of $120,000.

So how, according to FIRE, do you gain financial independence?  There’s one idea from behavioral science that captures the basic approach particularly well: Make saving your default action. Instead of saving whatever’s left after your monthly spending, spend whatever’s left after saving. It’s all about frugal living, disciplined budgeting, and smart investing, usually in low-cost index funds with a strong track record. Most adherents follow the 25x and 4% heuristics: Save 25 times the annual expenses needed in retirement and withdraw no more than 4% of your retirement pot per year.

Needless to say, FIRE has many critics. The perception is that many FIRE followers hate their day jobs, prompting some to ask whether a career change or self-employment wouldn’t be a more realistic option. “FIRE fighters” also argue that the movement’s retirement promise is overstated, as many its “retirees” continue to supplement their income through work. (Yet there is also a soft interpretation of FIRE that mainly stresses self-fulfillment through greater financial control.) In addition, the austerity needed to reach early financial independence not only jeopardizes a person’s well-being in younger years, it can also isolate people socially, requiring many followers to find partners and communities that share their values and life goals.

FIRE makes for an interesting analysis from a psychological perspective. In the first instance, an individual obviously needs to have the requisite personality traits to fit the lifestyle espoused by the movement. Personal experiences and situational factors, such as work satisfaction, will certainly contribute to one’s motivation to plan early retirement. As with any financial decision, there are also behavioral factors (good and bad) at work. Survivorship bias and confirmation bias may lead to distorted expectations as a result of the FIRE community’s inspiring narratives and success stories. Another pitfall is about the movement’s timing in relation to investments. Young FIRE investors are likely to be anchored on the post-recession market. Assuming that their index funds will continue to grow at the rate they have in the past few years is problematic and evidence of extrapolation bias.

An arguably even more pertinent dimension of behavioral economics and finance relates to the way people think about the future, which can be divided into two types of biases:

1. How much people are oriented towards the present (vs future), and
2. how accurately people think about the future.

The first of these encapsulates concepts like time discounting and potential present bias—the degree to which people are willing to forego rewards in the present in favor of future payoffs. When it comes to future orientation, FIRE practitioners are every behavioral scientist and policy maker’s dream. They’re all about patience and self-control. No need to nudge them toward greater retirement savings. They take their own well-being—financial or otherwise—seriously.

When it comes to the second point, thinking realistically about the future, there could be challenges. Some individuals’ consumption patterns may follow the life-cycle model in economics, where consumption levels are about the same during the periods of saving for retirement and actual retirement. Others, however, may face a decrease in income and thus consumption during the latter years. In those cases, individuals planning for early retirement may fall into traps related to the projection bias by failing to anticipate how they will feel and behave in the future. They may overestimate the intrinsic importance of financial independence to their well-being or may not appreciate future desires. It’s easier to forecast future needs than wants.

The simple implication of this point may be best expressed in an Ancient Greek aphorism: “know thyself.” The path to financial self-fulfillment is paved with self-awareness.