Popular Personal Financial Advice versus the Professors (James Choi, NBER)
This econ paper about personal finance was featured in a recent Freakonomics Radio episode. It compares the financial advice in popular personal finance books with what economics research says is optimal financial behavior.
Some of the most surprising (to me) recommendations in the paper:
Itās actually suboptimal to put away a fixed percentage of your income as savings every year. Instead of smoothing your savings, you should smooth your consumption so that you spend the same amount of money every year. Since most peopleās earnings potential peaks in midlife, itās best to have a small or even negative savings rate early in your career, and save the largest percentage of your income toward the midpoint of your career.
Smoothing consumption over time makes sense to me. If you know that you will be able to earn a fixed amount of money over your lifetime, then you ought to spend it evenly over time, as this maximizes your utility at each point in time given diminishing marginal utility of spending.
However, consumption smoothing implies a different optimal strategy for those interested in jumping from a high-paying career to a less highly paying one such as entrepreneurship, nonprofit work, or the arts. In general, your savings rate should be highest when your earnings potential is highest. But if you expect to earn the most early in your career, then thatās when your savings rate should be the highest. For these people, saving a fixed % of your income is probably closer to the right move.
Many popular finance books recommend overweighting U.S. stocks relative to the international stock market, since U.S.-based multinational companies provide exposure to international markets and international stocks carry a number of risks such as currency risk and weaker accounting and financial transparency standards. However, most economists reject arguments for overweighting the U.S. market, recommending instead that āevery investor should hold each countryās securities in proportion to its market capitalizationā (p. 16).
First, the costs and perceived risks of exposure to international stocks are too small to justify the amount of home bias that we see among investors.
Second, āthe correlation of multinationalsā stock returns with their domestic stock market is very high, limiting the international diversification benefit obtained by buying the multinational stocks of oneās own countryā (p. 17).
Third, any perceived strengths and weaknesses of each countryās stock market would be factored into the prices of their stocks.
Adjustable-rate mortgages (ARMs) are generally preferable to fixed-rate mortgages (FRMs) except when interest rates are at historical lows. This is because FRMs are exposed to inflation risk whereas ARMs are not; ARM interest payments tend to fluctuate 1-to-1 with inflation rates. Also, āARMs usually charge lower interest rates than FRMs because ARM interest rates are pegged to short-term interest rates, whereas FRM interest rates are pegged to long-term interest rates and include a premium for offering the refinancing optionā (p. 20).
Pop personal finance advice is probably logistically and emotionally easier for the average person to implement than the recommendations of the econ literature, except for relatively simple ones like ādonāt overweight the U.S. marketā. For example, following a rule of thumb like saving 10% of your income every year is easier on the brain than figuring out how to smooth your consumption based on your current and projected future earnings. Morgan Housel, the personal finance writer who was interviewed for the Freakonomics episode, repeatedly stresses that, unlike the econ literature, the advice of popular finance books accounts for the fallibility of the human mind. However, if youāre like me, you probably get peace of mind by doing the economically optimal thing, even if itās trickier. For those of us who value optimal personal finance strategy, following the recommendations of the econ literature might be worth the challenge.
In my opinion, a major reason why many people are not following the advice of economists is that economists donāt spend enough time promoting the views of the field to the general public. This is true in the realm of public policy, where simplistic talking points crowd out expert opinion on many issues, but itās also true in personal finance. Personally, I was not even aware that the econ literature had many recommendations for personal finance other than the widely-publicized āinvest in low-cost index fundsā. Even one personal finance podcast based on the results in the econ literature, simplified into heuristics that any person can follow, could help many people improve their finances.
Iām pretty sympathetic to the general idea of consumption smoothing over time based on oneās expected average lifetime income; in particular, I think there are often cases where people are unnecessarily miserly with their money at a younger age in order to hit a certain saving rate, which isnāt optimal for them.
However, one very important angle that informs a lot of this is the fact that we donāt have efficient capital markets, which specifically here means that people donāt have frictionless access to unlimited amounts of credit. This means that thereās a very meaningful sense in which a āzero balanceā is a meaningful lower bound, which means that it really does become important to save for emergencies, more than it otherwise would be (if your balance were allowed to go negative, then you wouldnāt need to save for emergencies that much, because you could always finance emergencies with credit and pay it back with future earnings).
A related angle, that further amplifies this, is the significant uncertainty people may have about their life trajectory and future earning potential. Depending on risk-aversion, therefore, it may make sense to adopt the āconsumption smoothingā strategy against not the median value of oneās expected average income, but against a lower percentile (e.g., the 5th percentile or 25th percentile). In such situations, people would generally appear to see increasing consumption over time as it becomes clearer to them that they are not at the tail of worst outcomes with respect to lifetime income.
A good example is students living very frugally and refusing to take out loans even on extremely favorable terms. Or when there are particularly large and predictable future income increases, such as after a residency or analogous period.
As an economist this makes me happy, but I feel it has to be pointed out that there are many assumptions underlying consumption smoothing that fail in consequential ways.
It assumes perfect credit markets. Saving is one thing, but if you think youāll earn more in the future, smoothing requires actually borrowing. And no bank will lend you money for personal consumption on the premise of āIām going to be good for it in a few years, just trust me broā.
For many plausible utility functions, marginal utility is convex (Uā²ā²ā²(C)>0) and the optimal thing to do is to save more when there is more uncertainty about your future incomeā¦ which is exactly what most people do, rather than just focusing on their expected future income.
(Most importantly) For most of us, the importance of saving is not smoothing across time but smoothing across states. I save not for my 65 year old self, but for myself tomorrow who breaks a limb and has to pay a large healthcare payment. Smoothing consumption over states is literally impossible in a world where we canāt draw perfect insurance contracts for every potential bad thing (or good thing) that we want to smooth over. When you have no insurance markets, itās pretty simple to establish that savings are the only way you have to smooth consumption across states.
So what should this mean for you? Well, a) your preferences matter; if you are āsufficiently risk averseā (Uā²ā²ā²(C)>0) then save more than a risk neutral person would. b) saving is the only way to truly insure yourself across states, to guard against bad shocks to your livelihood and wellbeing. If you, like OP, want to do the āeconomically optimalā thing, I think youād find that the answer will vary tremendously with your preferences and life circumstances, to the point where I think these frameworks should be taken as interesting ideas rather than prescriptions.
Wow, you made pretty much the same points (albeit with slightly different emphases) as I did in my comment https://āāforum.effectivealtruism.org/āāposts/āāRyRhT6EQjJgcwYmtd/āāpopular-personal-financial-advice-versus-the-professors?commentId=uDdooGQDbXwnBiieW
Youāre absolutely right, this is why I should read comments before posting redundancies at 2 am...
ARMs make sense in theory, but Iāve heard that in practice the embedded interest rate option tends to be underpriced because homeowners donāt always exercise when it would benefit them.