The best financial advice is more about psychology than economics
The number of books giving financial advice has taken off in recent years. A few of them, such as Robert Kiyosaki’s Rich Dad, Poor Dad have topped best seller lists.
According to Publishers Weekly, Kiyosaki’s book has sold more than 44 million copies.
However, very few, if any, of these books have been written by economists. And recent research suggests why.
Theory and practice
In a paper titled Popular personal financial advice versus the professors, James J. Choi from the Yale School of Management compared the advice given in 50 of the most popular personal finance books against mainstream economic theory.
What he found is that there are some notable differences.
For example, almost every personal finance author will subscribe to the idea that you should start saving as early as possible. Most recommended investing 10% to 15% of your salary every month from your first pay cheque.
Economic theory, however, would show that this isn’t optimal. It is more rational to save very little, or even nothing, when you are young, and to ramp up your saving in middle age when you are at your peak earnings potential.
The real world
The reason for this isn’t that hard to understand: how much you need to spend should increase at a lower rate through life than your earnings power.
A rational person wouldn’t, for example, sell their Toyota and buy a Range Rover when they started earning significantly more. They would instead use that increased disposable income to channel into their investments.
In a theoretical model, this would actually result in more savings.
In the real world, however, this is very rarely a good idea. That is because, quite simple, people are not wholly rational.
This is reflected in the three reasons why advising anyone to start saving as early as possible is far better advice, even if it is theoretically sub-optimal.
Where theory falls short
The first is that our lifestyles and our spending almost inevitably expand in line with our income. For example, few of us are satisfied to keep taking local holidays when we start earning enough to be able to travel to exotic places like Bali or the Maldives.
Secondly, one of the most powerful ways of influencing our behaviour is through forming habits. If saving becomes a habit early in life, it is much easier to sustain. If you put off saving until you are in your late 30s or early 40s, there’s a good chance that you will keep putting it off.
And, finally, the economic rationale is pretty difficult to understand. Just for example, here is Choi’s explanation for why delaying savings makes economic sense:
“In the standard lifecycle/permanent income hypothesis model with neither uncertainty nor borrowing constraints, individuals choose a consumption growth rate that trades off smoothing marginal utility (and hence the level of consumption) over time against the rate of time preference (i.e., the preference for earlier gratification) and the financial return from saving.”
Few people without an economics degree would have the faintest idea what he’s talking about. The advice to “save as much as you can, from as early as you can”, is far more simple, and compelling to the average person.
“Computable”
Choi himself recognises this. “Popular advice,” he writes, “is sometimes driven by fallacies, but it tries to take into account the limited willpower individuals have to stick to a financial plan, and its recommended actions are often easily computable by ordinary individuals,” he writes.
Another example is that most personal finance books recommend having an emergency fund that covers at least three months’ worth of living expenses. This is so that you can cope with any serious setback financially.
Economists, however, would see this as a waste of resources because there is huge opportunity cost in having this amount of money in a savings account. Investing that money in the stock market would be far more productive.
They would also argue that money is fungible — there is no need to put specific amounts of money aside for specific things. Any pound is the same as any other pound and can be transferred and used for anything.
Practically useful
But the concept of opportunity cost is not that simple to understand. People also take comfort in knowing that they have specific buckets of money to meet specific goals and needs. It is far easier to do the mental accounting this way. And academic research also shows that the motivation to save is higher if there is a clear link with what you are saving for.
These psychological considerations are where financial advice has its benefit. Even though, in theory, it may actually be encouraging people to do what is less than optimal, it is effective because it takes into account what they are actually likely to do.
As Choi notes: “Popular financial advice has two strengths relative to economic theory. First, the recommended action is often easily computable by ordinary individuals; there is no need to solve a complex dynamic programming problem. Second, the advice takes into account difficulties individuals have in executing a financial plan due to, say, limited motivation or emotional reactions to circumstances. Therefore, popular advice may be more practically useful to the ordinary individual.”