What economists get wrong about personal finance

In my defense, I did not find myself in financial trouble immediately after finishing my Masters in Economics. It took months. I had a decent paying graduate job and was living within my means, so how did it happen? Simple: I had “cleverly” put all my savings into a 90-day notice account to maximize the interest I was earning. When I was hit with my first tax bill, I had no way of meeting the payment deadline. wow

Fortunately, my father was able to save me. He had no background in economics, but three decades of extra experience taught him a simple lesson: things happen, so it’s better to keep some cash in reserve if you can. It was not the first collision between the formal economy and the school of life, nor will it be the last.

James Choi’s academic article “Popular Personal Financial Advice versus the Professors” recently caught my eye. Choi is a professor of finance at Yale. It’s traditionally a fiercely technical discipline, but after Choi agreed to teach an undergraduate class in personal finance, he dove into the popular financial self-help book market to see what gurus like Robert Kiyosaki, Suze Orman and Tony Robbins had to say. the subject

After reviewing the 50 most popular personal finance books, Choi found that what the ivory tower advised was often very different from what financial gurus were telling tens of millions of readers. There have been occasional outbreaks of agreement: most popular finance books favor low-cost passive index funds over actively managed funds, and most economists think the same. But Choi found more differences than similarities.

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So what are those differences? And who is right, the gurus or the teachers?

The answer depends on the guru, of course. Some are in the business of risky get-rich-quick schemes, or the power of positive thinking, or barely offer coherent advice. But even the most practical financial advice books deviate markedly from the optimal solutions calculated by economists.

Sometimes the popular books are simply wrong. For example, a common claim is that the longer you hold stocks, the safer they become. It is not true. Stocks offer more risk and more reward, whether you hold them for weeks or decades. (Over a long time horizon, they’re more likely to outperform bonds, but they’re also more likely to suffer some kind of catastrophe.) Still, Choi sees this error as doing little harm, because it produces reasonable investment strategies even if the logic is muddled. .

But there are other differences that should give economists pause. For example, standard financial advice is to pay off high-interest debt before cheaper debt, of course. But many personal finance books advise prioritizing smaller debts first as a self-help trick: Grab those small victories, the gurus say, and you’ll start to realize that a path out of debt is possible.

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If you think this makes any sense, it suggests a blind spot in standard economic advice. People make mistakes: they are subject to temptation, they do not understand the risks and costs, and they cannot calculate complex investment rules. Good financial advice will take this into account and ideally guard against the worst mistakes. (Behavioral economics has a lot to say about these mistakes, but tends to focus on politics rather than self-help.)

There’s one other thing that standard economic advice tends to get wrong: It mishandles what veteran economists John Kay and Mervyn King call “radical uncertainty”—uncertainty not just about what might happen, but types of the things that can happen.

For example, standard economic advice is that we should smooth consumption over our life cycle, accumulating debt when we’re young, accumulating savings in prosperous middle age, and spending that wealth in retirement. Well, but the idea of ​​a “life cycle” lacks imagination about all the things that can happen in a lifetime. People die young, go through expensive divorces, quit high-paying jobs to follow their passions, inherit handsome sums from rich aunts, earn unexpected promotions, or suffer from a chronic illness.

It’s not that these are unimaginable results, I just imagined them, but that life is so uncertain that the idea of ​​optimally spreading consumption over several decades starts to look very strange. The sound financial advice of saving 15 percent of your income no matter what may be inefficient, but it has a certain robustness.

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And there is one final omission from the standard economic worldview: we can simply waste money on things that don’t matter. Many financial sages, from the ultra-frugal Financial Independence, Retire Early (FIRE) movement to my own Financial Times colleague Claer Barrett (her book What they don’t teach you about money Hopefully he will soon surpass Kiyosaki), we emphasize this very basic idea: we spend thoughtlessly when we should spend mindfully. But although the idea is important, there is no way to even express it in the language of economics.

My training as an economist has taught me a lot about money, giving me justified confidence in some areas and justified humility in others: I’m less likely to fall for get-rich-quick schemes and less likely to think I can second-guess stocks. market However, my training was also sorely lacking. James Choi deserves credit for realizing that we economists do not have a monopoly on financial wisdom.

Tim Harford’s new book is “How to make the world add up

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