What economists get wrong about personal finance

To protect myself, I didn’t get into financial trouble right after completing my master’s degree in economics. It takes many months. I had a well-paying graduate job and was living within my means, so how did that happen? Simple: I “cleverly” put all my savings into a 90-day term account to maximize the amount of interest I earned. When I was surprised with my first tax bill, I had no way to meet the payment deadline. Oi.

Fortunately, my father was able to bridge the gap for me. He has no economic training, but his three decades of experience have taught him a simple lesson: things happen, so it’s best to have some cash on hand if you can. It was not the first clash between formal economics and the field of life, and it will not be the last.

Recently, I came across James Choi’s academic paper “Popular Personal Finance Advice Compared to Professors”. Choi is a professor of finance at Yale. It’s traditionally been a formidable technical subject, but after Choi agreed to teach a college class in personal finance, he dabbled in the popular financial self-help book market to see what What do masters like Robert Kiyosaki, Suze Orman and Tony Robbins say about it. subjects.

After surveying the 50 most popular personal finance books, Choi found that what the ivory tower advises is often very different from what tens of millions of readers are told by financial gurus. Occasional explosions of agreement: most popular finance books favor lower-cost passive index funds over actively-managed funds, and most economists think so . But Choi found more differences than similarities.

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So what are those differences? And who is right, the masters or the professors?

Of course, the answer depends on the guru. Some are trading risky get-rich-quick schemes, or the power of positive thinking, or barely giving any coherent advice. But even the more practical financial advice books are far from the optimal solutions calculated by economists.

Sometimes popular books are simply wrong. For example, a common claim is that the longer you hold stocks, the safer they become. Incorrect. Stocks offer more risk and more rewards, whether you hold them for weeks or decades. (Over a long period of time, they are more likely to perform better than bonds, but they are also more likely to experience some disasters.) However, Choi thinks the bug causes very little harm, because it produces sound investment strategies even if logical. is messy.

But there are other differences that should give economists pause. Standard economic advice, for example, is that one should pay off high-interest debt before cheaper debt, of course. But many personal finance books recommend prioritizing the smallest debts first as a life hack: grab those small wins, experts say, and you’ll begin to realize The way out of debt is possible.

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If you think this makes any sense, it shows a blind spot in standard economic advice. People make mistakes: they are easily tempted, misunderstand risks and costs, and are unable to calculate complex investment rules. Good financial advice takes this into account and ideally protects against the worst of mistakes. (Behavioral economics has a lot to say about such errors, but tends to focus on policy rather than self-help.)

There’s one more thing that standard economic advice tends to go wrong: it copes poorly with what veteran economists John Kay and Mervyn King call “radical uncertainty”—uncertainty. not only about what can happen, but also about what can happen. types about what could happen.

For example, the standard economic advice is that we should consume steadily throughout our lives, accumulate debt when young, accumulate savings in middle age, and then spend all of our wealth. that’s when you retire. That’s fine, but the idea of ​​the “life cycle” lacks the imagination of all the things that can happen in a person’s lifetime. People die young, go through costly divorces, give up high-paying jobs to follow their passions, inherit decent sums from wealthy aunts, win unusual promotions. suspect or have a chronic illness.

Not that these are unimaginable outcomes — I just imagined them — but life is so uncertain that the idea of ​​optimally allocating consumption over several decades begins to seem very strange. Either way, the outdated financial advice about saving 15% of your income may not work, but it does have some power.

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And there is one final flaw in the standard economic view of the world: we can simply squander money on things that don’t matter. Many financial sages, from the extremely frugal Financial Independence, Early Retirement (FIRE) movement to my Financial Times colleague Claer Barrett (her book What They Don’t Teach You About Money hope to outsell Kiyosaki soon), emphasize this very basic idea: we spend unconsciously while we should be spending consciously. But while the idea is important, there is not even a way to express it in the language of economics.

My training as an economist has taught me a great deal about the value of money, giving me legitimate confidence in some areas and legitimate humility in others. Other areas: I’m less likely to fall for get-rich-quick schemes and less likely to believe I can outperform the stock market. However, my training has missed a lot. James Choi deserves credit for realizing that we economists do not have a monopoly on financial intelligence.

Tim Harford’s new book is ‘How does the world add up?

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