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How popular personal finance advice compares to economic theory

Popular personal finance gurus dispense advice to millions of people. What are they telling their audience? This column summarises the advice from the 50 most popular personal finance books. The most significant divergences from economic theory occur in advice about savings and debt, where popular authors try to accommodate the limited willpower and motivation of their readers. Popular advice about the most important aspects of asset allocation ends up being largely similar to economic theory’s recommendations, but due to different reasoning.

Economics is supposed to help us make better economic decisions. Few economic decisions that we make are as personally important as those regarding our own finances. But financial literacy in the population is low (Lusardi and Mitchell 2014), which can cause significant welfare losses (Bhamra and Uppal 2018). So, are people turning to professional economists for guidance?

For many, the answer is no. Instead, they get personal finance advice from popular figures through books, radio, and television. Robert Kiyosaki’s book Rich Dad Poor Dad has sold more than 32 million copies. Dave Ramsey’s radio show attracts 18 million listeners per week.

What is this parallel universe of personal finance gurus telling its audience? To what extent is their advice in concordance with academic economic theory or rules of thumb that approximate the recommendations of academic economic theory (Love 2014)? Might popular advice help explain why people sometimes don’t behave in line with our theories’ predictions? Could popular advice teach economists that we have been missing something important about optimal financial decisions?

To begin the exploration of these questions, in Choi (2022), I survey what the 50 most popular personal finance books – as ranked by the website Goodreads – are telling their readers. I find that the most welfare-relevant deviations between popular advice and economic theory are in the savings and debt domains. These deviations are commonly driven by popular authors trying to accommodate the limited willpower and motivation of their readers. When it comes to the most important aspects of asset allocation, both camps end up making similar recommendations, but for different reasons.

Savings over the lifecycle

Economic theory recommends that individuals smooth their consumption over time – that is, consume a similar amount each period. The reason is that each successive dollar of spending within a period produces less happiness than the previous dollar, so it is better to consume a consistent, moderate amount each period than to deprive yourself in one period and splurge in the next. Because income tends to be low when young and high in middle age, economic theory recommends a low savings rate when young and a high savings rate in middle age.

In contrast, popular authors recommend that you smooth your savings rate: regardless of your age and circumstances, save 10–15% of your income during working life. They give two reasons for this recommendation. First, compound interest is powerful, so savings should start early in life. Economic theory takes compound interest into account too, but does not necessarily conclude that the optimal savings rate today should therefore be positive and high. Second, it is useful to establish saving consistently as a discipline. As popular author David Chilton writes, “most people aren’t going to be able to transition from setting aside nothing to being supersavers at the flip of a switch. Psychologically, that’s just not realistic.” This consideration is almost entirely absent from economic theory.

Debt repayment priority

Economists have a simple principle about optimal debt repayment: any dollars you devote to debt service should prioritise paying down the highest interest rate debt you have.

Among popular authors who give advice about debt repayment strategies, half recommend the economists’ strategy. But the other half recommend some variant of the debt snowball method: prioritise paying down the lowest-balance debt you have, regardless of its interest rate, because the positive feeling you get from zeroing out a debt account will motivate you to complete your debt repayment plan.

The co-holding puzzle

Economists have documented a puzzle about household debt management: a third of US households who are paying high interest rates on their credit card debt also have at least one month of income held in liquid assets that pay low interest rates (Gross and Souleles 2002). These households could profit by using their liquid assets to pay down credit card debt.

Surprisingly, many popular authors recommend co-holding low-interest assets and high-interest debt. The most common reason cited is that having to borrow additional amounts while on a debt repayment plan will discourage you from sticking to your plan. Therefore, it is important to have an asset buffer from which you can finance unexpected expenses that arise while you’re paying down your debt.

Asset allocation

For popular authors, investment horizon is the most important consideration for how much you should invest in stocks. Popular authors believe that stocks are risky over short holding periods but safe over long holding periods. Therefore, any money that might be needed in the short run – emergency savings, and sometimes also non-emergency savings that will be spent in the next five or so years – should be held in cash. Only money that is not needed in the short run should be invested in stocks, with the asset allocation of this long-term money becoming more conservative with age.

The above advice creates a portfolio percentage in equities that is hump-shaped with respect to age. The young have relatively little money that isn’t liable to be spent soon, so most of their money should be held in cash, even though their scant long-term money is predominantly in stocks. The middle-aged have more substantial savings, and retirement is still relatively far off, so they should hold a large percentage of their portfolio in stocks. The old should have a low portfolio equity share because they need to tap assets to finance retirement consumption in the near term.

Economists’ models also recommend a hump-shaped equity share, but for different reasons. Campbell et al. (1997) survey the empirical literature and conclude that “there is little evidence of mean reversion of long-horizon [stock market] returns” of the form popular authors believe in. Instead, the most robust reason for portfolio equity share to decline with age is human capital. Wages are relatively uncorrelated with stock returns, so your future labour income is like a bond. When you are young, you have many future wage payments remaining, so the value of the implicit fixed-income position embodied in your human capital is high. Therefore, you should take more risks in your financial portfolio. When you are older, you have fewer future wage payments remaining, so the value of your human capital is low. Hence, you should reduce the risk in your financial portfolio to compensate. In addition, when you are very young, your asset allocation should be somewhat more conservative because you have little savings to buffer against labour income shocks.

Benchmark economic models predict that everybody should have at least some positive amount invested in the stock market. In reality, many people do not participate in the stock market. A leading hypothesis explaining non-participation is the existence of a fixed cost of stock market participation, which is motivated by the fact that stock market participation rates increase with wealth (Vissing-Jørgensen 2003). If the fixed cost of participating in the stock market is €300 per year, then it is not worthwhile investing in stocks if you have only €1,000 available to invest, but it is worthwhile to pay that cost if you have €100,000.

The popular advice to hold in cash any money that might be spent in the near term provides an alternative explanation for stock market non-participation that is absent from the academic literature. Because low-wealth individuals have a greater chance of spending any money they do have in the near term, following such advice naturally creates stock market participation rates that increase with wealth.

Mortgage choice

Popular authors overwhelmingly recommend fixed-rate mortgages (FRMs) over adjustable-rate mortgages (ARMs) on the grounds that the former are safer.

In reality, FRMs expose the borrower to risks too, since the present value of their real payments is decreasing in the inflation rate during the life of the mortgage. Moderate inflation during the life of the mortgage creates a higher payment burden on the borrower.

In contrast, the present value of real ARM payments is almost completely insensitive to the inflation rate. But ARMs expose borrowers to short-term real payment shocks, because an increase in inflation expectations increases nominal debt payments today even though the price level has not risen yet. Additionally, ARMs impose a real payment burden that varies positively with the real short-term interest rate. On the other hand, ARMs charge lower interest rates than FRMs on average.

Integrating all these considerations, the models of Campbell and Cocco (2003, 2015) find that borrowers should usually prefer ARMs over FRMs, contrary to popular advice.

Conclusion

Popular financial advice often deviates from the recommendations of economic theory. My sense is that when it does so in the domain of asset allocation, the economists generally have it right. I am less sure of this when it comes to savings and debt. Normative economic models assume perfect self-control and motivation. Economists have little advice to offer those who struggle to stick to a financial plan and need second-best workarounds to keep ourselves on track. Rather than letting non-economist gurus fill this void, perhaps economists should begin developing financial advice for the rest of us.

References

Bhamra, H S, and R Uppal (2018), “The Financial Mistakes of Households and Their Social Costs”, VoxEU.org, 18 October.

Campbell, J Y, and J Cocco (2003), “Household Risk Management and Optimal Mortgage Choice”, Quarterly Journal of Economics 118: 1449-1494.

Campbell, J Y, and J Cocco (2015), “A Model of Mortgage Default”, Journal of Finance 70: 1495-1554.

Campbell, J Y, A W Lo, and A C MacKinlay (1998), The Econometrics of Financial Markets, Princeton, NJ: Princeton University Press.

Choi, J J (2022), “Popular Personal Financial Advice versus the Professors”, Journal of Economic Perspectives, forthcoming.

Gross D B, and N S Souleles (2002), “Do Liquidity Constraints and Interest Rates Matter for Consumer Behavior? Evidence from Credit Card Data”, Quarterly Journal of Economics 117: 149-185.

Love, D (2014), “Optimal Rules of Thumb for Personal Finance”, VoxEU.org, 27 January.

Lusardi, A, and O S Mitchell (2014), “The Economic Importance of Financial Literacy: Theory and Evidence”, Journal of Economic Literature 52: 5-44.

Vissing-Jørgensen, A (2003), “Perspectives on Behavioral Finance: Does ‘Irrationality’ Disappear with Wealth? Evidence from Expectations and Actions”, NBER Macroeconomics Annual 2003: 139-194.

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