Popular personal finance advice contradicts economic theory

Popular personal finance advice contradicts economic theory

Avoid credit card debt. Start an emergency fund. Start saving for retirement when you’re young. And never underestimate the importance of compound interest.

Personal Finance Experts tend to agree on this kind of basic principles. But a new working paper highlights the surprising disconnect between popular personal finance books and economic theory.

The author of the article, James J. Choi, professor of finance at Yale, first combed through the 50 most popular personal finance books according to Goodreads in 2019. This list includes well-known tomes like this by Robert Kiyosaki. rich dad, poor dadby Jesse Mecham You need a budgetand Ramit Sethi I will teach you how to be richas well as several books by great finance gurus like Suze Orman and David Ramsey. Then he compared the most common teachings of books on personal finance with the assumptions and principles of mainstream economic theory.

The paper, published by the National Bureau of Economic Research, has not yet been peer reviewed.

Choi finds that personal finance experts are diverging from economists on the best approaches to economymanage your financial portfolioby reimbursing debtand home ownership. But while personal finance experts may be wrong about some things, Choi says their advice has two advantages over economic theory: it’s easy for laypeople to understand, and they approach money matters with human constraints. (such as the difficulty of stick to a budget) in mind.

The psychology of personal finance

The table below offers a brief summary of the difference between personal finance and economic advice, according to Choi’s article. Out of five areas, the only point on which both parties are in complete agreement is actively managed mutual funds. The consensus: It’s hard to beat the market. Picking out index funds In place.

Why does personal finance advice so often deviate from economic theory? The article suggests that the first group tends to take psychology into account, while the second operates in a purely rational world.

For example, many personal finance experts want people to get into the habit of saving a certain portion of their income even when they are young and broke, so that it will be easier for them to keep putting more and more money in. more money set aside as their income increases. In contrast, economists tend to think it makes sense for people to save little (or even go into debt) early in their careers, and then accelerate saving dramatically as they start earning more money. .

Similarly, Choi finds that nine books on personal finance advocate what Dave Ramsey calls the “snowball method” of paying off credit card debt, in which people first pay off their lowest balances, whatever regardless of the interest rates on various cards. This flies in the face of economists’ very practical assumption that eliminating debt is best prioritized with the highest interest rates. But he notes that Ramsey and his ilk offer the snowball method as a way to help people stay motivated to get out of debt, on the assumption that people will be more likely to stay on track if they don’t. they get small wins along the way.

The best way to save, according to personal finance books

The document also contains interesting information on the most common tips from personal finance books. For example, of the 25 books that contained specific advice on the size of the ideal emergency fund, the majority recommended saving at least three months of living expenses.

Choi notes that economists tend to think about savings very differently from personal finance experts. They take into account factors such as opportunity cost– for example, the trade-off that building a strong savings account might prevent you from investing that money in the stock market or buying a new car to replace the one that will eventually cost you thousands of dollars in repairs. And on the whole, academics are aware of how excessive savings can harm the economy, which depends on people spending money on various goods and services.

Personal finance experts need not worry about these kinds of ripple effects. Their goal is just that: personal.


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