Where most personal finance books go wrong
James Choi, a professor at Yale University, was interested in teaching another course on personal finance. He wanted his curriculum to mix the conclusions of technical economics essays with insights from glittering best-sellers.
A few years ago, he began poring over dozens of popular finance-related titles that had sold tens of millions of copies to get an idea of the advice they were giving. “I really started to get interested in this universe of advice and how it differed from the advice we academics gave about saving and investing,” he told me. He recognized that the most popular books tended to offer financial advice that either differed significantly from academic research or, as he put it, was “just plain wrong”.
Choi distilled 50 best-selling lessons on saving, spending, and investing and juxtaposed them with the insights of mainstream economics research. This month he published the findings in a new article: “Popular Personal Financial Advice Versus the Professors”. His conclusion: economists tend to give rational advice because they are dealing with numbers; Best sellers tend to offer more practical advice because they deal with human behavior – with all its chaos and irrationality.
Perhaps the most glaring example of the difference between economists and popular writers was the advice on debt reduction. In economic theory, Choi said, households should always focus on prioritizing paying off their highest-interest debt. Any other strategy is more expensive since you’re just leaving higher interest lingering on your monthly bill.
But popular authors like Dave Ramsey have proposed an almost opposite approach. According to Ramsey’s “debt snowball” method, you should pay off your debts from smallest to largest and gain motivation and momentum as you zero your accounts. This is far from the cheapest strategy for paying down debt, Ramsey admits. But his debt snowballing approach isn’t about technical efficiency. It’s about building willpower. When people who are overwhelmed by their debts see a smaller account reach zero, it’s so rewarding that they’re motivated to keep paying off their larger balances.
Choi stressed that he didn’t necessarily agree with Ramsey’s approach strategically wrong, although technically fallacious: “I see it like diet and exercise. You can tell people to eat broccoli and steamed chicken for their entire lives. Or you can tell people about cheat meals to get their approval so they are motivated to stay on the diet.”
The best-sellers’ emphasis on building momentum and motivation sometimes leads to less than sensible suggestions. For example, popular books often insist that people should by all means save at least 10 percent of their income. You can think of this strategy as “smoothing” your savings rate: rain or shine, you’re advised to put away a steady portion of your income to build a saving habit over time.
But life is not smooth. It’s pointed. Many people who make barely enough to afford rent by the age of 25 become rich enough to be able to easily afford a suburban house by the age of 40. Some parents, swamped with day care costs, find a huge chunk of money free when their kids transfer to public school. For this reason, Choi said, academics tend to defend low or even negative savings rates for young people in anticipation of higher savings rates in midlife. This is the opposite of flattening your savings rate; it is consumption smoothing.
These methods are more than competing personal finance strategies; they are almost like competing philosophies of life. Flattening your savings pays homage to a psychological reality: habits require discipline and practice. If most people are bad at suddenly changing their saving habits in middle age, then it’s reasonable to advise them to make sacrifices when they’re young.
But consumption smoothing pays homage to an existential reality: life itself is the ultimate scarce commodity. The future is unpredictable, and maintaining a double-digit savings rate during life’s worst storms isn’t paramount. For example, a special dinner with friends at 23 is more valuable than having a few hundred dollars more in your retirement savings at 73. Using this logic, building a budget that will make you comfortable and happy in the short term, even if that means varying your savings rate from decade to decade (or year to year), is a better approach.
This might be the deepest takeaway from Choi’s article. Personal finance bestsellers succeed because they combine theory and psychology in a way that takes human nature seriously and therefore deserves the respect of business professors. But those who spend their lives delaying gratifications may one day be rich in savings but poor in memories because they sacrificed too much pleasure on the altar of compound interest.
Perhaps many of the most popular books on personal finance could take a page from economic theory: There’s more to life than optimized saving habits.
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