Popular personal finance advice contradicts economic theory – Vophs

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

Personal finance experts agree on these basic principles. But a new working paper highlights a surprising connection between popular personal finance books and economic theory.

The paper’s author, James J. Choi, a finance professor at Yale, first reviewed the 50 most popular personal finance books of 2019, according to Goodreads. This list includes well-known subjects such as Robert Kiyosaki. Rich father, poor fatherJesse Meachams You need a budget.and by Ramit Sethi I will teach you to be rich., as well as numerous books by well-known finance gurus such as Suze Orman and Dave Ramsey. He then compared the most common takeaways 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The paper, published by the National Bureau of Economic Research, has not yet been peer-reviewed.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 finds that personal finance experts differ from economists on the best ways to save, manage your financial portfolio, pay off debt and own a home. But even though personal finance experts can be wrong about some things, Choi says their advice on economic theory has two advantages: It’s easy for laypeople to understand, and it connects with human constraints to money matters. come to mind (such as difficulty sticking to a budget).

The psychology of personal finance

According to Choi’s paper, the table below provides a quick summary of how personal finance and economic advice differ. Among the five subject areas, the only issue on which both sides fully agree is the active management of mutual funds. Consensus: The market is hard to beat. Opt for index funds instead.

Why does personal finance advice so often deviate from economic theory? The paper suggests that the former group takes psychology into account, while the latter is operating 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’re young and broke, so it’s easier for them to Keep allocating more money as your income grows. Conversely, economists think it makes sense that people may save very little (or even go into debt) early in their careers, then when they start making more money. If they are, they will speed up the savings.

Similarly, Choi found that nine personal finance books 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. pay This flies in the face of the most pragmatic assumption of economists that it is better to prioritize getting rid of the debt with the highest interest rate. But he notes that Ramsey and his team offer a snowball approach to help motivate people to become debt-free — working under the idea that if people take small wins along the way, So they are more likely to stay on track.

The best way to save, according to personal finance books

This article also includes some interesting insights into the most common advice gleaned from personal finance books. For example, of the 25 books that had specific advice on the size of an ideal emergency fund, the majority recommended putting away at least three months of living expenses.

Choi notes that economists think about savings quite differently than personal finance experts. They consider factors such as Opportunity cost—For example, building a strong savings account can prevent you from investing that money in the stock market, or buying a new car to replace one that will cost you thousands of dollars to repair. And in the bigger picture, academics are aligned with these practices. Excess savings The economy can suffer, depending on how much money people spend on different goods and services.

Personal finance experts don’t have to worry about these kinds of knock-on effects. Their focus is just that: personal.

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