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:
- It's 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 people's earnings potential peaks in midlife, it's 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 that's 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 "every investor should hold each country’s securities in proportion to its market capitalization" (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, "the correlation of multinationals’ stock returns with their domestic stock market is very high, limiting the international diversification benefit obtained by buying the multinational stocks of one’s own country" (p. 17).
- Third, any perceived strengths and weaknesses of each country's 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, "ARMs 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 option" (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 "don't overweight the U.S. market". 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 you're like me, you probably get peace of mind by doing the economically optimal thing, even if it's 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 don't 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 it's 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 "invest in low-cost index funds". 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.
I think it generally makes sense to try to smooth personal consumption, but that for most people I know this still implies a high savings rate at their first high-paying job.
For the point about smoothing consumption, does that actually work given that retirement savings are usually invested and are expected to give returns higher than inflation? For instance, my current savings plan means that although my income is going to go up, and my amount saved will go up proportionally, the majority of my money when I retire will be from early in my career.
For a more specific example, consider two situations where I'm working until I'm 65 and have returns of 6% per annum (and taking all dollar amounts to be inflation adjusted):
In the first situation, if I contribute $1000 monthly, I'll retire with about $2.4 million, 79% of which is from interest. In the second situation, to get the same amount at retirement, I have to contribute $2500 monthly, and only 63% of the balance will be from interest. I don't expect to be making 2.5 times as much at 35 as I was at 21, so smoothing consumption is worse for me.
This gets even worse when you consider than you should move to lower risk investment plans as you get closer to retirement, since you'll have to be contributing even more. As an counterpoint to this, some people even recommend investing on the margin when you're young to get even higher returns, though I'm not bold enough to do that.
I guess my biggest disagreements with the paper is that income (for at least me and for people I have compared notes with) is not hump-shaped enough for the effect to dominate, and their assumption that "the rate of time preference equals the interest rate" seems to be to simply not be true even though economists like to assume it is. I think the second assumption is the one I disagree with more, since I (and again, many people I have talked to) have very little time preference for the present. If I had two buttons, to give me $1000 of consumption today, or $1001 of consumption in thirty years (inflation adjusted of course), I would press the second button. But economists assume that I would only do that if the second button was something like $6000 (a 6% annual rate of return).
I suspect that assumptions like this are why economists disagree with personal finance guidelines, and I suspect that the personal finance guidelines are more often correct about their assumptions than economists are.
This sounds nuts to me. Firstly, what about risk? You might be dead in 30 years. We might have moved to a different economy where money is worthless. You might personally not value money (or not value the kind of things you can get with money) as much. Admittedly there's also some upside risk, but it's clearly lower than the downside.
We're ignoring investment possibilities, of course. But even then, in any case, if you have £1000 now, you can use it to buy something that would last more than 30 years and benefit you over that time.
The risk is a good point given some of the uncertainties we’re dealing with right now. I’d estimate maybe 1% risk of those per year (more weighted towards the latter half of the time frame, but I’ll assume that it’s constant), so perhaps with a discounting rate of that it would need to be more like $1400. That’s still much less than the assumption.
Looking at my consumption right now, I objectively would not spend the $1000 on something that lasts for more than 30 years, so I believe that shouldn’t be relevant. To make this more direct, we could phrase it as something like “a $1000 vacation now or a $1400 vacation in 30 years”, though that ignores consumption offsetting.
ARMs make sense in theory, but I've heard that in practice the embedded interest rate option tends to be underpriced because homeowners don't always exercise when it would benefit them.