Tag: Paycheck

Managing your money is obviously an important part of being a responsible adult. But how should you do that? It turns out that there’s a large gulf between the advice given by the authors of popular finance books and academic economists.

In a new study titled “Popular Personal Financial Advice versus the Professors,” the Yale financial economist James Choi rummages through 50 of the most popular books on personal finance to see how their tips square with traditional economic thinking. It’s like a cage match: Finance thinkfluencers vs economists dueling over what you should do with your money.

And, yes, Choi is an economist, but he may be a more impartial referee of this smackdown than you’d think. That’s because he’s a behavioral economist who doesn’t swallow the canon of old-school economics hook, line, and sinker. Traditional economic models portray humans as hyper-rational, disciplined creatures, who always make optimal financial choices for themselves. Behavioral economics, which has pretty much taken over the field, emphasizes that people are quirky, often irrational, and prone to errors.

In a way, Choi says, behavioral economists like him try to help people overcome their shortcomings and achieve their financial goals as if they were the savvy creatures of old-school theory. And so, he says, classic economic theory may still provide a good overall guide for how to maximize your financial well-being. But, Choi says, the advice of popular finance thinkfluencers, who tend to concentrate on helping us overcome our flaws and foibles, might actually be more effective in some cases.

So, who’s right in this financial royal rumble? The authors of self-help finance books or the stalwarts of traditional economic theory? While Choi doesn’t always provide definitive answers, this debate might spark some ideas on how you can more effectively handle your finances.

How Should You Save Money?

When it comes to saving money, many economists offer somewhat counterintuitive — and, dare I say, potentially irresponsible — advice: if you’re young and on a solid career track, you might consider spending more and saving less right now.

That’s because you’re likely going to earn a bigger paycheck when you’re older, and to really squeeze the enjoyment out of life, it might make sense to live a bit beyond your means at the moment and borrow from your future, richer self. Economists call this “consumption smoothing,” and it’s a feature of standard economic models of how rational people save and invest over their lifetime.

The idea, Choi says, is “you don’t want to be starving in one period and overindulged in the next. You want to smooth that over time.” The sort of ideal scenario: you start off adulthood saving little or nothing or even taking on debt, then you save a lot during your prime-age earning years, and then you spend those savings when you retire.

“I tell my MBA students, ‘You of all people should feel the least amount of guilt of having credit card debt, because your income is fairly low right now but it will be, predictably, fairly high in the very near future,'” Choi says. Once they start making money, he says, they should probably pay down that debt quickly since credit card companies charge high interest rates.

Reading through popular finance books, however, Choi finds that the vast majority of popular authors offer advice that contradicts this approach: throughout your life, the thinkfluencers say, your goal should be to live within your means and save a consistent percentage of your income. It doesn’t matter if you’re 20 or 30 or 50; they implore you to stash money away immediately and invest it for your future.

In arguing this, the thinkfluencers often cite the power of compound interest. The longer you save money, the more interest it accrues. As a result, wealth snowballs over time, so saving a large percentage earlier could make a lot of sense.

Of course, economists also recognize the power of compound interest. Where thinkfluencers and old-school economics really depart from each other, Choi says, is “the usefulness of establishing saving consistently as a discipline,” Choi says. This motivation, he says, “is almost always missing from economic models of optimal saving — [and is] a potentially important oversight.” In other words, some of us might need to adopt hard-and-fast saving rules at a young age to develop the discipline needed to lead more affluent lives, even if that’s less than optimal from a traditional economic perspective.

So who wins on this point? “I’m actually agnostic about it,” Choi says. “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.”

How Should You Think About Your Budget?

In old-school economics, money is money. It’s fungible. There is no reason to put labels on it. Absent some financially advantageous reason to do so (like the ability to get subsidies or a lower tax rate), it doesn’t make sense to set aside savings for specific purposes, like a new car or a future vacation or a down payment on a house. A dollar is a dollar.

Of course, many people don’t think this way. They often do what behavioral economists call “mental accounting,” earmarking special money for this and that. “In more extreme versions of mental accounting, you cannot use the money that you’re saving for your Hawaii vacation for the down payment on your future house,” Choi says.

Choi finds that 17 of the 50 books he read through advocate for some sort of mental accounting exercise. And, he says, this advice might actually make sense. It makes financial calculations easier for people and may motivate them to accomplish their goals.

Should You Be “House Rich, Cash Poor”?

Many Americans live in enormous houses and are stretched thin paying for them. While their house is a valuable asset, and they’re technically pretty rich, they’re just squeaking by, living paycheck to paycheck. People generally refer to this as “house rich, cash poor.”

Choi says both popular financial advisers and most economists are pretty clear: don’t do this! Don’t buy a house you can’t really afford. That can be super stressful and potentially ruinous.

How Much Of Your Money Should Be In Stocks?

Choi says that popular advisors and economists also generally agree that when you’re young, you should invest most of your money in stocks and only a little bit in bonds. Moreover, Choi says, both camps agree that as you get older, you should get more conservative, rebalancing your portfolio away from stocks and more towards bonds because stocks are riskier than bonds. But, Choi says, while both of these groups advise people to do the same thing with their investments over time, their reasoning for doing so is very different.

Generally speaking, popular financial advisers say that, while stocks are risky in the short run, you should invest mostly in them when you’re young because they earn higher returns than bonds over the long run. “The popular belief is that the stock market is kind of guaranteed to go up if you just hold onto it for long enough,” Choi says. “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.”

But while popular authors may discount this risk over the long term, their advice recognizes that holding stocks is risky in the short term. That’s why they argue that, as you get closer to retirement, you should get out of stocks and go into bonds, which are generally less risky. A popular rule of thumb: 100 minus your age is the percentage of your portfolio that should be in stocks. The remainder should be in bonds. So if you’re 30, you should be 70 percent in stocks and 30 percent in bonds.

While economists agree that you should get more conservative over time with your financial portfolio, Choi says, their reasoning is more nuanced.

“For almost all working people, the major economic asset they have is their future wage income,” Choi says. In other words, think of your work skills (your “human capital”) as part of your financial portfolio. It’s like the biggest form of wealth you own, and it’s generally safer than stocks or even bonds. 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.

Should You Care Whether Stocks Pay Dividends?

Choi says there are some popular financial books that advise people to buy stocks that pay dividends. For the uninitiated, dividends are checks that companies send to their shareholders typically every quarter. “There seems to be this fascination with generating ‘income’ from your investments,” Choi says.

Economists, generally speaking, think this is dumb. “If I need to spend some money from my wealth, I don’t need to wait for the company to send me a check,” Choi says. “I can just sell some shares and use the proceeds from that sale to finance my expenditure needs. And so there should be no reason why I prefer stocks that pay dividends versus stocks that don’t pay dividends. And in fact, dividends are tax-disadvantaged. So, a stock that pays dividends is going to put a bigger tax burden on you, all else equal, than a stock that doesn’t pay dividends.”

Choi is with Team Economist on this one.

Should You Invest In Foreign Stock Markets?

Economic theory stresses the importance of diversifying your investments. This, Choi says, is true of diversifying the countries you invest in, too. Theoretically, the more countries you invest in, the less risky your investment portfolio will be. Some countries will do well. Others will do poorly. “So economic theory would say you want a diversified portfolio that holds a bit of every country’s stock market in the world,” Choi says.

But people don’t do this. They exhibit what economists call “home bias.” The French are more likely to invest in French companies. The Japanese are more likely to invest in Japanese companies, and so on. This has long been a puzzle to economists. The answer may lie in the almost universal support for ‘investing at home’ among the thinkfluencers. “The striking thing about the popular authors is that they all recommend home-biased portfolios,” Choi says. Choi isn’t really sure whether this makes much sense. “It just seems to be a little bit of jingoism, where people just like the stocks that they are familiar with.”

Should You Invest In Actively Managed Funds or Passive Index Funds?

Actively managed funds are those where you pay an expert to pick and choose stocks for you. These fund managers charge big fees with the promise of higher returns. Index funds have nobody actively picking and choosing investments for you. These funds simply passively hold a small piece of each major company in the stock market, thereby earning the overall average market return.

Economists and thinkfluencers agree on this one, too. “Everybody basically says you should go with index funds,” Choi says. “The data are pretty compelling. On average, passive funds outperform actively managed funds.”

Choi’s Big Takeaway

So who wins? The thinkfluencers or the economists? Economists, Choi suggests, may know a lot about how people should act. But, as an empirically minded behavioral economist, Choi recognizes that people often don’t act this way. And that’s where he has a degree of sympathy for the popular authors. “Given that we have all these quirks and frailties, we might have to resort to strategies that are less than perfect.”

“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.” He certainly has that right.

By: Greg Rosalsky