518. Are Personal Finance Gurus Giving You Bad Advice?

Money is a topic that is often driven by emotion, attaching various feelings like excitement, fear, lust, and regret. It is essential to start a conversation and seek advice about money from trustworthy sources to make informed decisions. Some of the reliable sources could be YouTube channels like The Financial Diet, financial podcasts like The Money Guy Show and Afford Anything, and educational resources like Ray Dalio's “How the Economic Machine Works.” Starting a conversation about money can help in breaking the taboo and understanding the psyche behind our daily decision-making.

Despite the abundance of personal finance advice on the internet, it is important to be cautious when it comes to seeking financial advice. While popular money advisors may have helped many people, there are significant differences between their recommendations and what economists would suggest. Most economists have little to say about personal finance as it is a complicated problem that may lead to a messy solution. However, there are economists who specialize in household finance and can offer valuable advice. When seeking financial advice, it is crucial to consider the source and their qualifications rather than simply relying on popularity.

Most economists don't care about household finance because it was historically seen as 'women's work' and separate from the serious fields of corporate finance and asset pricing, according to a theory proposed by an elder statesman in the profession. However, researchers like Professor Choi have become interested in behavioral finance - the study of why people make irrational financial decisions - and are now investigating popular personal-finance books for practical, on-the-ground advice. Choi selected the top 50 personal-finance books on Goodreads and conducted a close textual analysis of relevant passages to explore how their advice differs from that of traditional finance professors. His findings suggest that personal-finance books often lack empirical evidence and may promote risky or unrealistic financial behaviors. Thus, consumers should approach personal-finance advice critically and seek guidance from unbiased sources.

While pop-finance books and their authors have become increasingly popular, it's important to note that some of the best financial advice can come from academic economists. A study comparing the advice of popular finance books to that of economists found significant differences in recommendations for issues like home mortgages, debt repayment, and savings. The authors of finance books tend to make concessions to human frailty, while economists focus on building discipline and virtue through habits like consistent saving. Economists advise saving little in your twenties and becoming a super-saver in your late thirties and forties to smooth consumption over time. This simple conception of human joy and sorrow has a significant impact on personal finance.

The concept of consumption smoothing suggests that we should adjust our spending over time to match our changing life circumstances, rather than adhere to a consistent spending plan. This may mean spending more during certain periods, such as when getting married or living in a high-cost-of-living city, and less during others. However, many popular finance books recommend instead to smooth saving, by consistently setting aside a percentage of income each year. Economists argue that adjustable-rate mortgages are generally preferable to fixed-rate mortgages, as they allow for flexibility in response to changing market conditions. But these recommendations may not be suitable for everyone's individual circumstances, and should be evaluated on a case-by-case basis.

Fixed-rate mortgages may not always be the safest option due to the hidden risk associated with inflation rates. On the other hand, adjustable-rate mortgages may be considered low-risk as they are less volatile and offer lower interest rates. It is advised to opt for an adjustable-rate mortgage, unless the fixed-rate mortgage rates are historically low or if one is stretching their budget to buy a home. However, despite economic theory advising for adjustable-rate mortgages, many economists themselves do not follow this advice, possibly due to lack of expert thought or knowledge on the optimal mortgage choice.

Economists prioritize high-level research over low-hanging household-finance questions, which often leads to a lack of personal finance management knowledge. The professional incentives in the field push economists to focus on abstract models instead of practical advice. It's no surprise that most people prefer to get their personal-finance advice from authors of popular books like Morgan Housel, who has sold over two million copies of his Psychology of Money book. Housel's practical finance advice focuses on the behavior and psychology behind money management, which economists often overlook. It begs the question, why do we look to economists for personal-finance advice? While they may be smart and good at math, they may not understand how to think like a human.

Psychology plays a big role in our financial decisions, but traditional economics often ignores this fact. While academic economics teaches a math-based subject with one right answer, the real world is much more influenced by emotions, psychology, sociology, and keeping up with the Joneses. This gap between the two can be miles apart, making it difficult for individuals to make informed financial decisions. However, new advancements in behavioral economics - a blend of economics and psychology - are revolutionizing the industry by incorporating human behavior into financial models. While traditional economists may still believe they have the 'right' answer when it comes to personal finance, the reality is much more complicated.

Personal finance is not an exact science; our emotions play a big role in how we handle money. Our past financial behavior often indicates how we will behave in the future. Though we may be wired to certain emotional responses, breaking bad financial habits is possible and worthwhile. The financial services industry and consumer economy incentivize us to spend money, often against our best interest. However, we can change our habits and demand companies do better. When it comes to eradicating consumer debt, economists suggest paying off the highest interest debt first. Taking control of our finances and educating ourselves can help us make better decisions in the future.

When it comes to debt repayment, there are different schools of thought. While half of the popular authors believe in focusing on the debt with the highest interest rate, the other half espouses the 'debt snowball' method. The debt snowball involves paying off the smallest debt first to gain motivation and tackle bigger debts. Dave Ramsey, a popular personal finance expert, endorses the debt snowball method, even though it may not be mathematically optimal since it promotes behavior change and quick wins. Morgan Housel and others agree that Ramsey's approach may not be perfect but recognize its practicality and the impact it has had on people. Ramsey's success also seems to be fueled by word of mouth, and there is some evidence of his positive impact on debt reduction

Saving and spending less is a consistent message given by Ramsey, and listeners exposed to his radio show have been found to decrease household expenditures by at least 5.4 percent. The effectiveness of debt repayment strategies remains unclear, and economists have differing opinions on the role of mental accounting. While most economists discourage dividing money into separate buckets, individuals find peace of mind in doing so. The best approach is the one that an individual can stick to, much like how the Mediterranean or Atkins diet can both lead to achieving a healthy weight. Therefore, if the debt-snowball method motivates someone, that could be the right approach for them. It's important to acknowledge that there is no one size fits all approach to personal finance, and the focus should be on finding the best strategy that works for the individual situation.

Mental accounting can help people stay motivated to save money for specific goals, like a Hawaii vacation. This concept, introduced by economist Richard Thaler, involves creating separate mental accounts for different expenses or goals. It makes it easier to track progress and see how small contributions add up towards a larger goal. Additionally, the act of contributing to a mental account can make the goal feel more attainable. However, some economists argue that mental accounting is not necessary and that all money should be considered equal. There is also a debate about whether investors should prioritize stocks that pay dividends, since the stock's price typically drops after a dividend payment. Overall, the use of mental accounting and the value of dividends are both topics for individuals to consider based on their own financial goals and priorities.

Investing in the stock market is a good idea, but many U.S. households don't own stocks due to the fixed cost of investing and pessimism about returns. Dividend stocks give a tangible view of success but may not be the most efficient way to return capital. Passive index funds are generally better than actively managed funds, as the latter incurs trading costs, tax burdens, and other expenses. Investing in a low-cost index fund, like those pioneered by Jack Bogle, is the way to go. Overall, it's important to invest in the stock market to build financial progress.

The index fund was opposed by many brokers and investors, who believed it was 'un-American' and settling for average. However, it proved to be a practical investment strategy with its low costs and no portfolio turnover. Jack Bogle, the godfather of the index fund, was a contrarian person who remained confident in his investment strategy despite facing opposition. However, even he made decisions that seemed antithetical to his beliefs, such as investing in his son's active fund. This highlights the reality of messy financial decisions and the contradiction that can exist in them. The biggest money mistakes shared by listeners included taking out too much student debt and not understanding the impact of maxing out credit limits.

Having a rainy-day savings buffer is crucial as emergencies are predictable and having at least a couple of months income salted away should be a high priority. Personal debt instruments are easy to get but hard to get out of, therefore, understanding them is important. Saving money is more important than spending it on impractical things. Though the personal savings rate was higher in the past, it is still important to save and deprive oneself of certain pleasures to ensure a moderate level of deprivation both today and tomorrow, rather than very little now and a lot in the future.

Due to the more developed economic system and social safety net, Americans tend to save less than the Chinese. However, it could also be due to the greater temptation to spend with easier access to credit cards and marketing techniques. To avoid financial trouble, it is recommended to have no more than 50-60% of your income committed to inflexible spending, as living paycheck to paycheck with illiquid assets can lead to stress. Paying off a mortgage with a low interest rate may not be the best financial decision, as leftover money can be invested in the stock market for a higher return.

Paying off a low-interest mortgage may not always make financial sense according to economists, but it can provide a sense of independence, freedom, and stability for some households. Morgan Housel chose to pay off his mortgage to maximize how well he and his family slept at night, rather than just trying to maximize return and generate the highest net worth. Having a sense of control over his future was important to him, and paying off the mortgage achieved that. While it may not make sense on a spreadsheet, for some people, emotional and psychological benefits outweigh financial benefits.

While buying a house may provide a psychological benefit of stability and ownership, the financial returns may not necessarily be better than renting. Additionally, owning a home may lead to more investment in the property and community, but also increased wear and tear. It ultimately comes down to personal preference and what provides the most satisfaction for an individual.

Popular financial advice may deviate from normative economic theory due to its focus on being realistic and easily understandable by ordinary individuals, making it more practically useful to the general public. Economists' focus on complex theories often leads them to overlook the difficulties individuals face in executing financial plans due to limited motivation or emotional reactions. Rather than ceding this territory to non-economists, further research should focus on developing normative economic models that incorporate these features, and that are more in line with how people actually make financial decisions. Ultimately, the effectiveness of financial advice lies in its ability to resonate with and be acted upon by the general public, rather than being purely theoretical.

Managing personal finances doesn't have to be overly complicated. While it may be difficult to reach the optimal solution due to the vast amount of factors involved, it's quite possible for the average person to arrive at a reasonable plan that ensures a comfortable life and a stress-free existence. While models designed by economists don't account for all personal and societal complexities, there are countless resources and services available to help make sound financial decisions. Success in personal finance is attainable, but requires effort and diligence in understanding available options and making informed decisions. Overall, it's important to approach personal finance with a strong and proactive mindset.