What economists get wrong about personal finance


In my defence, I didn’t get into financial trouble immediately after finishing my master’s degree in economics. It took months. I had a decently paid graduate job and was living within my means, so how did it happen? Simple: I had “cleverly” put all my savings in a 90-day notice account to maximise the interest I earned. When I was surprised by my first tax bill, I had no way of meeting the payment deadline. Oops.

Fortunately, my father was able to bridge the gap for me. He had no economics training, but three decades of extra experience had taught him a straightforward lesson: stuff happens, so it’s best to keep some ready cash in reserve if you can. It wasn’t the first collision between formal economics and the school of life, and it won’t be the last.

My eye was caught recently by James Choi’s scholarly article “Popular Personal Financial Advice versus the Professors”. Choi is a professor of finance at Yale. It’s traditionally a formidably technical discipline, but after Choi agreed to teach an undergraduate class in personal finance, he dipped into the market of popular financial self-help books to see what gurus such as Robert Kiyosaki, Suze Orman and Tony Robbins had to say on the subject.

After surveying the 50 most popular personal finance books, Choi found that what the ivory tower advised was often very different to what tens of millions of readers were being told by the financial gurus. There were occasional outbreaks of agreement: most popular finance books favour low-cost passive index funds over actively managed funds, and most economists think the same. But Choi found more differences than similarities.

So what are those differences? And who’s right, the gurus or the professors?

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 barely offer any coherent advice at all. But even the more practical financial advice books depart strikingly from the optimal solutions calculated by economists.

Sometimes the popular books are simply wrong. For example, a common claim is that the longer you hold equities, the safer they become. Not true. Equities offer both more risk and more reward, whether you hold them for weeks or for decades. (Over a long time horizon, they are more likely to outperform bonds, but they are also more likely to hit some catastrophe.) Yet Choi reckons that there is little harm done by this error, because it produces reasonable investment strategies even if the logic is muddled.

But there are other differences that should give the economists some pause. For example, the standard economic advice is that one should repay high-interest debts before cheaper debts, of course. But many personal finance books advise prioritising the smallest debts first as a self-help life hack: grab those small wins, say the gurus, and you’ll start to realise that a path out of debt is possible.

If you think that this makes any sense, it suggests a blind spot in the standard economic advice. People make mistakes: they are subject to temptation, misunderstand risks and costs, and cannot compute complex investment rules. Good financial advice will take this into account, and ideally defend against the worst errors. (Behavioural economics has plenty to say about such errors, but has tended to focus on policy rather than self-help.)

There’s another thing that the standard economic advice tends to get wrong: it copes poorly with what the veteran economists John Kay and Mervyn King term “radical uncertainty” — uncertainty not just about what might happen, but the kinds of things that might happen.

For example, the standard economic advice is that we should smooth consumption over our life cycle, accumulating debt while young, piling up savings in prosperous middle age, then spending that wealth in retirement. Fine, but the idea of a “life cycle” lacks imagination about all the things that might happen in a lifetime. People die young, go through expensive divorces, quit well-paid jobs to follow their passions, inherit tidy sums from rich aunts, win unexpected promotions or suffer from chronic ill health.

It’s not that these are unimaginable outcomes — I just imagined them — but that life is so uncertain that the idea of optimally allocating consumption over several decades starts to seem very strange. The well-worn financial advice of saving 15 per cent of your income, no matter what, may be inefficient but has a certain robustness to it.

And there is a final omission from the standard economic view of the world: we may simply squander money on things that do not matter. Many financial sages, from the ultra-frugal Financial Independence, Retire Early (FIRE) movement to my own colleague at the Financial Times, Claer Barrett (her book What They Don’t Teach You About Money will hopefully soon be outselling Kiyosaki), emphasise this very basic idea: we spend mindlessly when we should spend mindfully. But while the idea is important, there is no way even to express it in the language of economics.

My training as an economist taught me plenty of value about money, giving me justified confidence in some areas and justified humility in others: I am less likely to fall for get-rich-quick schemes, and less likely to believe I can outguess the stock market. Yet my training missed a lot too. James Choi deserves credit for realising that we economists have no monopoly on financial wisdom.

Tim Harford’s new book is ‘How to Make the World Add Up

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