Suze Orman, Dave Ramsay, Robert Kiyosaki, Ramit Sethi – together these sorts of personal finance gurus have sold tens of millions of books and shaped popular understanding of what it means to be financially savvy. They are very influential, but are they really right?
Not always, if you ask an economist. For a recent NBER article, Yale finance professor James Choi did a favor for all entrepreneurs who want to manage their money wisely. Choi read the 500 best personal finance books according to Goodreads, comparing their recommendations to the consensus opinion of academic economists.
How successful have the gurus been? While the professors agree with the experts on many issues (like index funds being your best bet for investing), they also differ significantly on a handful of important issues.
1. Always save at least 10% of your income.
If there’s one thing almost all personal savings gurus agree on, it’s that you, really should save more. And you were supposed to start yesterday. “Of the 45 books that offer savings advice, 32 emphasize the importance of starting to save right away and 31 revel in the power of compound interest,” reports Choi. “Twenty-eight books mention the need for everyone to prioritize building up an emergency savings buffer.”
Since saving for emergencies is as uncontroversial as it is in personal finance, you might be surprised to learn that the “always save a fixed amount” rule isn’t actually endorsed by economists. Instead, the consensus view among academics is that you should invest in yourself (and your joy) when you’re young and relatively poor, and increase your savings in middle age when you’re hopefully earning. the, much more.
2. Use the snowball method to pay off your debts.
You don’t need a PhD in economics to do the math on this one. Just about anyone can instantly see that paying off the debt with the highest interest rate will save you money, but Choi was surprised to find that many books advocated yet another approach.
The “snowball method,” popularized by Dave Ramsay, advises instead to pay off the smallest debt first until you reach a zero balance, then move on to the next smaller debt. “You need quick wins or you’ll lose momentum and get discouraged…every time you cross a debt off the list, you get more energy and momentum,” says Ramsay.
3. Opt for a fixed rate mortgage.
Choi’s article devotes a lot of space to the question of whether you should go for a fixed rate mortgage (FRM) or an adjustable rate mortgage (ARM). There is no simple answer to this question, with borrowers needing to consider the current interest rate, inflation risk, refinancing costs and how long you are likely to stay in the home. But Choi concludes that gurus are generally more positive about FRMs than professional economists.
According to a classic economic model, “borrowers should generally prefer ARMs to FRMs, unless interest rates are low,” Choi notes.
Why Economists Differ From Personal Finance Gurus
On the face of it, it might not seem like you should blame yourself for not contributing to your IRA at age 23 and should consider some basic math when deciding which debt to pay off first. These are indeed useful pointers, but as several commentators have pointed out, the most profound lesson seems to be that popular authors have a much better understanding of how human beings behave than professors armed with complex formulas.
While the advice of this world’s Suze Ormans and Ramit Sethis isn’t mathematically ideal in all cases, it does a great job of accounting for people’s laziness, self-delusions, and psychological quirks. Saving 10% of your income right out of college might not make economic sense, but it takes seriously how terrible people are at changing their habits once they’re set. The snowball method is mathematically crazy, but it makes perfect sense motivationally.
“Best-selling personal finance books succeed by blending theory and psychology in a way that takes human nature seriously,” The Atlanticit is Derek Thimpson points this out, but also warns that “those who spend their lives delaying gratification may one day find themselves rich in savings but poor in memories, having sacrificed too much joy on the altar of compound interest.”
Which is a good summary overall, but less so for most entrepreneurs. Math is powerful, but so is psychology. The best personal finance strategy is probably the one that comes closest to the mathematical ideal that you can actually achieve in real life.