Popular personal finance advice goes against economic theory

Avoid credit card debt. Create an emergency fund. Start saving for retirement at a young age. And never underestimate the importance of compound interest.

Personal finance experts tend to agree on this type of basic principles. However, a new working paper highlights the surprising disconnect between popular personal finance books and economic theory.

The paper’s author, Yale finance professor James J. Choi, first combed through Goodreads’ 50 most popular books on personal finance in 2019. This list includes well-known books like those by Robert Kiyosaki Rich father, poor fatherJesse Mechams You need a budgetand Ramit Sethis I will teach you to be richas well as several books by leading finance gurus such as Suze Orman and David Ramsey. He then compared the most common insights from personal finance books to 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The paper, published by the National Bureau of Economic Research, has not yet been peer-reviewed.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 notes that personal finance experts differ from economists on the best approaches save upmanagement of your financial portfoliorepay faultand home ownership. But while personal finance experts can get some things wrong, Choi says their advice has two advantages over economic theory: it’s easy for laypeople to understand, and they approach money matters with human limitations (eg Be tied to a budget) in the head.

The psychology of personal finance

The table below provides a brief summary of how personal finance and business advice differ according to Choi’s paper. Across five subject areas, the only point on which both parties fully agree is this actively managed mutual funds. The consensus: It’s hard to beat the market. Choose index funds instead of this.

Why does personal financial advice so often deviate from economic theory? The paper suggests that the former group tends to take psychology into account, while the latter operates in a purely rational world.

For example, many personal finance professionals want people to make a habit of saving a certain portion of their income, even when they are young and broke, so that it becomes easier for them to put more and more money aside as their income increases. In contrast, economists tend to think it makes sense for people to save little early in their careers (or even go into debt) and then accelerate saving significantly when they start making more money.

Similarly, Choi notes that nine books on personal finance advocate what Dave Ramsey calls the “snowball method” of paying off credit card debt, in which people pay off their lowest balances first, regardless of interest rates on different cards. This contradicts economists’ very practical assumption that it is best to get rid of debt with the highest interest rates. But he notes that Ramsey and his ilk offer the snowball method to help people stay motivated to get out of debt — on the theory that people are more likely to stay on track if they make small gains in the process.

Best way to save according to personal finance books

The paper also includes some interesting insights into the most common pieces of advice found in personal finance books. For example, the majority of the 25 books that gave specific advice on the size of the ideal emergency fund recommended saving at least three months of living expenses.

Choi notes that economists tend to think very differently about saving than personal finance experts. They take into account factors such as Opportunity costs– For example, the trade-off could be that building a solid savings account will keep you from putting that money in the stock market or buying a new car to replace the one that will ultimately cost you thousands of dollars in repairs. And by and large, academics are set on how to do that excessive saving can hurt the economy that depends on people spending money on various goods and services.

Personal finance professionals need not worry about such knock-on effects. Her focus is just that: Personal.

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