A Yale Professor Takes a Look at Popular Financial Tips

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Personal finance is a popular topic, as managing, investing, and budgeting money is an imperative part of life. However, just how you should do that depends entirely on who you ask. And there is certainly no shortage of experts, talking heads, and influencers ready to give their opinion.

There is a large rift between financial advice given by the authors of popular financial books and economists within academia. According to a new study by Yale financial economist James Choi titled, “Popular Personal Financial Advice versus the Professors,” everything is not quite what it seems. Choi explores the advice given in 50 of the most popular personal finance books to see how their financial wisdom measured up with more traditional economic thinking.

Though Choi is an economist, he maintains more of a neutral stance. He is a behavioral economist who does not necessarily follow the traditional economic model, which paints people as fiercely rational decision-makers who always make the most suitable financial decisions. On the contrary, behavioral economists emphasize that people are often irrational and prone to making fallacies in logic.

Choi’s Angle

According to Choi, behavioral economists aim to help individuals overcome their financial shortcomings and reach their goals as if they actually were the type of people that old-school economic theory was modeled after. While Choi concedes that classic economic theory may still be a good overall outline to follow, he also says that advice from popular finance talking heads may concurrently be quite effective as well. Advice from proponents on this side of the aisle tend to focus on individuals overcoming their flaws and quirks, advocating that this approach is more effective than traditional means.

While Choi does not state who is definitively right, whether proponents of traditional economic theory or the authors of self-help personal finance books, he does ignite an interesting dialogue. The research and subsequent debate certainly can provide the framework for how you can more effectively handle your finances and attain your financial goals.

Here are some of Choi’s thoughts on personal finance.

Saving Money

Choi points out that many economists offer counterintuitive advice regarding saving money: spending more and saving less if you are young and on a steady career path. The logic behind this is that you will likely have a bigger paycheck when older, and you should enjoy spending more when you are young. Essentially, you are borrowing from your future self, which you are counting on as being wealthier.

This “consumption smoothing,” as coined by economists, is a feature of traditional economic models. The ideal scenario of this theory would be starting adulthood, saving little to nothing while potentially taking on debt, then saving substantially during your prime earning years and subsequently spending those savings upon retirement.

However, according to popular financial advice books, the lion’s share of the author’s advice contradicts this method. These “thinkfluencers,” as Choi refers to them, believe that your goal should be to live within your financial means while saving a substantial amount of income, regardless of how old or young you are.

Their logic in this comes back to the idea of compound interest; the longer you save money, the more interest will accrue. The resulting effect is that money snowballs over time, so saving more earlier on can make more sense.

Choi acknowledges that these thinkfluencers are not the only ones to recognize compound interest and its benefits. Where they and the old-school economics crowd begin to drift apart is over “the usefulness of establishing saving consistently as a discipline,” according to Choi. He also recognizes that this motivation is nearly always missing from traditional economic models. In other words, some people may need hard discipline early on in their adult lives to live more affluent lives later on, even though that would contrast with traditional economic perspectives.

While Choi is impartial on which practice is the best, he sees the practicality of both sides. “On the one hand, I do have a lot of sympathy for the view that you might be unnecessarily depriving yourself in your twenties and even thirties when, very predictably, your income will likely be much higher in later decades. That being said, I do think that there is something to this notion of being disciplined and learning to live within your means at a young age.”

Formulating a Budget

In traditional economics, ideas on budgeting are more cut and dry. A dollar is a dollar, and setting aside savings for specific purposes does not make sense.

Obviously, most people do not subscribe to this way of thinking. Many people engage in what behavioral economists call “mental accounting,” whereby they earmark specific money for certain things, although it is fluid and can change its purpose. For example, you could use the money saved for an annual vacation or as a downpayment for a new car.

In contrast to traditional economic thinking, Choi reports that 17 of the 50 books he researched for the study encourage mental accounting. He also believes this might make sense; it makes the math and calculations easier for many people and certainly can provide motivation to accomplish set goals.

Choi’s Thoughts on “House Rich, Cash Poor”

The phrase “house rich, cash poor” refers to Americans who live in vast houses far beyond their means and are financially stretched thin trying to afford them. Though their house is a valuable asset, they are still struggling along, living paycheck to paycheck.

Choi points out that both popular financial advisors and the majority of economists strongly advise against this.

How Much Should You Invest in Stocks?

Popular advisors and economists also found more common ground: they agree that when you’re young, you should invest most of your money into stocks and put less into bonds. Both parties also agree that as you get older, your investments should gradually become more conservative, shifting away from potentially volatile stocks and more toward bonds. However, although both parties agree on what to do, their reasoning for doing it is quite different.

Popular financial advisors generally agree that although stocks are risky in the short term, investing in them when younger should earn you higher returns over bonds over the long haul. The thought process is that the stock market will correct itself and go back up should there be a crash. Choi disagrees.

“Now, this is just not true. And you can see this in Italy and Japan. In Japan, the stock market still hasn’t recovered to the level it was back in 1989. So it’s not true that stocks will always win over the long run. Bad things can happen.”

Though the thinkfluencers may disregard this risk over a longer investment horizon, they do acknowledge that holding stocks is risky in the short term. This is why they argue that you should invest more into bonds as you approach retirement. A popular trick is: 100 minus your age is the percentage of stocks that your portfolio should be. So, if you are 25, then 75 percent of your portfolio should be in stocks and 25 percent in bonds.

Economists also agree that you should be more conservative with age, although their reasoning differs.

According to Choi, one major economic asset that is often overlooked is their future income. Financially savvy people should consider their skills as part of their financial portfolio.

“When you’re young, this safer form of wealth is a huge part of your portfolio, so you can balance it with risky stocks. Sure the stock market might crash, but you still have the security of being able to earn money at your job for many more years. As you get closer to retirement, this safer asset, your labor, represents a much smaller part of your portfolio—and that makes it much more scary to be all-in on risky stocks. ”That’s why you should become more conservative in your financial portfolio allocation over time,” Choi says.

Choi’s Closing Thoughts

So which party has the right idea?

Choi acknowledges that economists know much more about how people should act and spend their money. However, that is a bit more idealistic, as people often do the opposite. In this regard, Choi sympathizes with the popular personal finance authors and sums up his thoughts with an analogy.

“I think of it in terms of diet,” Choi says. “The best diet is the one that you can stick to. Economic theory might be saying you need to be eating skinless chicken breasts and steamed vegetables for the rest of your life and nothing else. That’s going to be the best for your health. And, really, very few people will actually do that.”

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