What economists are wrong about personal finance

What economists are wrong about personal finance

In my defense, I didn’t get into financial trouble right after I finished my master’s in economics. It took months. I had a well-paying graduate job and lived within my means, so how did it happen? Simple: I “smartly” put all my savings into an account with 90 days’ notice to maximize the interest I earned. When I was surprised by my first tax bill, I had no way to meet the payment deadline. oops.

Fortunately, my father was able to bridge the gap for me. He had no background in economics, but three decades of additional experience had taught him a simple lesson: things happen, so it’s best to keep some cash in reserve if possible. It was not the first collision between the formal economy and the school of life, and it will not be the last.

My attention was recently drawn to James Choi’s scholarly article “Popular Personal Financial Advice vs. the Professors.” Choi is a finance professor at Yale. It’s traditionally a formidably technical discipline, but after Choi agreed to teach an undergraduate class in personal finance, he dove into the market for popular financial self-help books to see what gurus like Robert Kiyosaki, Suze Orman, and Tony Robbins had to say. . the topic.

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

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 offer hardly any coherent advice. But even the most practical financial advice books stray surprisingly far from the optimal solutions calculated by economists.

Sometimes the popular books are just wrong. For example, a common statement is that the longer you hold shares, the safer they become. Is not true. Stocks offer more risk and more reward, whether you hold them for weeks or decades. (Over a long time horizon, they are more likely to outperform bonds, but they are also more likely to hit a catastrophe.) However, Choi acknowledges that this mistake does little harm, because it produces reasonable investment strategies even if the logic is fuzzy.

But there are other differences that should give economists pause. For example, standard financial advice is that one should 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 gains, gurus say, and you’ll begin to realize that getting out of debt is possible.

If you think this makes any sense, it suggests a blind spot in standard economic advice. People make mistakes: they are subject to temptation, misunderstand risks and costs, and fail to calculate complex investment rules. Good financial advice will take this into account and ideally defend you against the worst mistakes. (Behavioral economics has a lot to say about such mistakes, but it has tended to focus on politics rather than self-help.)

There’s another thing that standard economic advice tends to get wrong: It copes badly with what veteran economists John Kay and Mervyn King call “radical uncertainty”: uncertainty not just about what might happen, but about the guys of things that can happen.

For example, standard economic advice is that we should smooth consumption throughout our life cycle, racking up debt when we’re young, accumulating savings in prosperous middle age, and then spending that wealth in retirement. Fine, but the idea of ​​a “life cycle” lacks imagination about all the things that can happen in life. People die young, go through costly divorces, quit high-paying jobs to follow their passions, inherit sizable sums from wealthy aunts, win unexpected promotions, or suffer from chronic illnesses.

It’s not that these are unimaginable results, I just imagined them, but life is so uncertain that the idea of ​​optimally allocating consumption over multiple decades is starting to seem very strange. The hackneyed financial advice to save 15 percent of your income, no matter what, may be inefficient but it has some soundness.

And there is one final omission from the standard economic view of the world: we can just waste money on things that don’t matter. Many financial savants, from the ultra-frugal Financial Independence, Early Retirement (FIRE) movement to my own colleague at the Financial Times, Claer Barrett (his book What they don’t teach you about money hopefully it will soon outsell Kiyosaki), emphasizes this very basic idea: we spend mindlessly when we should be spending mindfully. 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 taught me a lot about value for 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 believe I can outperform stocks. market. However, my training also missed a lot. James Choi deserves credit for realizing that economists don’t have a monopoly on financial wisdom.

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

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