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Book Smart?

Adam M. Grossman

JAMES J. CHOI is a finance professor at Yale University. But in a recent paper titled “Popular Personal Financial Advice versus the Professors,” Choi played the role of (somewhat) neutral arbiter. The question he sought to answer: Do popular—that is, non-academic—personal finance books offer advice consistent with the academic literature? And if not, is that a problem?

To conduct his study, Choi looked at 50 personal finance titles including The Millionaire Next DoorRich Dad Poor DadA Random Walk Down Wall Street and I Will Teach You to Be Rich. As you might guess, Choi found a sizable disconnect between the academic literature and the advice offered by popular titles.

For example, academic studies advocate an approach to budgeting called “consumption smoothing.” The idea is that, when people are early in their careers and their incomes are low, they should save very little, leaving them with more cash for living expenses. In fact, the theory goes, young people should even take on debt so they can enjoy a reasonable standard of living while their incomes are low. As Choi puts it, “You don’t want to be starving in one period and overindulged in the next.” According to this theory, workers shouldn’t start saving until later in their careers, when their incomes are higher.

That’s what the academic literature says. Most personal finance books, though, recommend the opposite: The standard advice for young people is to avoid debt—other than a mortgage. Recognizing the power of compound interest, young people should also start saving as soon as possible rather than delaying.

Another disconnect with the academic literature: Popular books recommend that investors diversify internationally but still maintain the bulk of their investments in U.S. stocks. Academics, however, look down on this approach. They call it “home bias” and believe it’s illogical to favor any one country’s stock market over another. Choi, in fact, accuses personal finance authors of “jingoism” and maybe laziness. “People just like the stocks that they are familiar with,” he says.

Another key point of disagreement between academics and popular books: To facilitate saving, books often recommend that consumers segregate money using different accounts. You might have an emergency fund, for example, that’s separate from your day-to-day checking account.

This setup can help people get organized, and it can help them measure progress toward specific goals. That makes intuitive sense, but economists see it as foolish. They call it “mental accounting” and believe that it, too, is illogical. In the academic view, money is fungible, so there’s no reason to segregate funds in different accounts.

Those are just some of the disagreements. On several other points, as well, Choi found that popular books don’t adhere to many of the key findings in the finance literature.

As an investor, what should you make of this? Is it a problem that personal finance books, in Choi’s view, seem to have so little basis in research? To answer this question, I would consider four points:

1. Investing isn’t easy. Investors are human beings. It’s no surprise, then, that much of the popular literature is focused on practical solutions. Choi himself acknowledges this. Ordinary people need solutions that are “easily computable” and not complex, he says. He goes on to say that individuals may be susceptible to “emotional reactions to circumstances” and might need to fight against “limited motivation.”

These observations have a condescending tone, but they may also be correct. Intuitively, many of us know the right thing to do. We shouldn’t overspend, carry high-interest debt and so forth. What’s needed, then, isn’t so much formulas as practical solutions. That’s what most personal finance books offer. Most of their recommendations aren’t really counter to the academic literature. Instead, they just select the most important findings and translate them into recommendations that are usable.

2. Risk isn’t so simple. Very few popular books look at risk the way economists do. Formal economics uses volatility—the variability of returns from year to year—as the primary measure of risk. This is the basis for Modern Portfolio Theory. But it also has a flaw: Volatility is a backward-looking statistic. No one can say what the volatility of an investment will be in the future—and that, of course, is all that matters.

There’s the joke that Bernie Madoff only had one bad year. If you had looked at the volatility of his firm’s returns before his scheme unraveled, it would have looked great. But that would have overlooked other, non-quantitative risk factors. Critics noted that Madoff didn’t use a traditional custodian, that his math didn’t add up and that he carefully avoided people who questioned him too closely. None of those risks would have shown up in a traditional economic analysis.

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To be sure, Madoff is an extreme example. The reality, though, is that all investments carry risks that are multi-dimensional. Using only the academic lens would be foolish. In that way, then, it’s a good thing that popular authors deviate from the academic understanding of risk.

3. Historical data is—necessarily—about the past. It’s important to remember that research studies are backward-looking. That’s a problem because the past is only a guide to the future. It offers no guarantees. For that reason, it’s not surprising if popular advice looks beyond historical data.

A good example: Historically, value stocks have outperformed growth stocks. But very few authors would tell readers to put all their money into value stocks. Why? This historical outperformance was only on average and over time. It hasn’t been true in every time period, and there are no guarantees that it’ll be true in the future.

Further, when it comes to historical data, there’s always an additional risk: that the pattern observed historically might have been just a fluke, without any fundamental basis.

Finally, we each get to make just one financial journey. Like most investors, I reference charts that go back to the 1920s. But I also recognize that no one will be in retirement for 100 years—so those long-term averages can’t be applied directly to any one individual.

4. Finance is not a physical science. Each year, the Nobel Committee issues a prize in “economic sciences.” The reality, though, is that economics isn’t a science in the same way that physics or chemistry is. Economics can only approximate how the world works. Because the economy is so complex, it’s impossible to ever know for sure how things will turn out.

Consider our experience with inflation over the past few years. A portion of it was perhaps the predictable result of stimulus spending. But no one could have predicted Russia’s invasion of Ukraine, which made matters worse. These sorts of things happen all the time. An economic model might predict one thing, but then something else happens.

In his survey, Choi found quite a bit of disagreement between academic research and popular books. He also found quite a bit of dispersion among the personal finance books themselves. On the one hand, this might sound discouraging. My sense, though, is that this confirms what we already knew: Personal finance has some quantitative underpinnings, and academic research does provide many useful insights. But ultimately, it’s a balance. No formula can perfectly explain the real world. Thus, there’s a danger in relying solely on the numbers. At the same time, academic research does provide an important leg of the stool.

A final thought: Choi did identify one—and only one—area in which there was broad agreement between academics and popular authors. On the topic of mutual funds, nearly all agreed that index funds were a better bet than actively managed funds.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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Steve Spinella
Steve Spinella
20 days ago

I’ve learned a lot from the academics, including about behavioral finance. Of course, applying what I know is usually a bit harder than learning some more. Speaking of Yale professors, though, there is a great course on Coursera by Robert Schiller called “Financial Markets.” Knowing what the most privileged (Yalies?) need to know is itself a bit of a privilege, and it cost me nothing except time. https://www.coursera.org/learn/financial-markets-global

John Wood
John Wood
22 days ago

I’m reminded of Warren Buffett’s line that you wont’ find an economist on the Forbes 400 list. I’ll take Bob G’s 10 commandments below over any academic paper every written.

Joe Cyax
Joe Cyax
22 days ago

Intuitively, many of us know the right thing to do.” I think most all “self-help” books (on any subject) capitalize on this – everyone really knows mostly what to do, they just don’t want to do it because it is hard – certainly harder than not doing it. So the books (if they are not trying to scam you into some foolish investment scheme) are trying to nudge you to do what you know you should be doing.

Now retired, I have been managing my money, mostly according to the generally accepted good behaviors (saving, using IRAs, not borrowing excessively, index investing, etc.) for decades and have the net worth that was “predicted” based on these behaviors (i.e. enough money and then some). 

But at the start of it all, other than saving, I did not know anything about investing. When I went looking for help (circa mid 90s), a man that ran a small financial management firm gave me the book “The Wealthy Barber”. It had a large effect on me. It nudged me to do the what I came to believe was the right thing.

One of the counter arguments to what I did (looking back at history and expecting/hoping it would repeat itself) is your well made point: “Historical data is—necessarily—about the past. It’s important to remember that research studies are backward-looking. That’s a problem because the past is only a guide to the future. It offers no guarantees.” Anyone who has read “The Black Swan” is well aware of the huge potential risk of just this. But, way back in my 30s, what else would I or could I reasonably do? The market may melt down this year and never recover – but the earth might also be hit by an asteroid – so, I’ll stay with learning from history and letting it guide me for now. Back during the 2008 financial crisis, I was as freaked out as everyone else. But I remember saying to my wife something like, “I don’t understand this or know what is going to happen, so all I can do is follow the lessons that history offers”. So we did, and just let all the investments ride, and came out fine.

So my over-arching point is that everyone needs to learn some good money management/investing behaviors: simple stuff that is easy for a 20-something to digest and put into practice. I could have started by reading Wade Pfau or Michael Kitces, but quite frankly, back then, for me, it would have been like putting an 8th grade student in college physics (I would have been turned off pretty quickly). So all these books, scholarly or not, if they get people to look at the topic and start seeing all there is to it – they will have served a useful and important purpose. 

Now excuse me while I go bid for some NFTs and maybe buy some crypto (kidding!)

Bob G
Bob G
24 days ago

OK, here are my financial Ten Commandments for the youngsters from an old guy (not Moses). Obviously, these have all been said by others much wiser than I.

  1. Thou shalt complete high school without the burden of a child.
  2. Thou shalt choose college and a career or trade carefully.
  3. Thou shalt not take on college debt that is unrealistic based on your job opportunities and expected earnings.
  4. Thou shalt pick your life partner as if it is the most important decision of your life because it is.
  5. Thou shalt not have children before you marry.
  6. Thou shalt live below your means at all stages of your life.
  7. Thou shalt invest early and often whenever possible. (16 is not too early and weekly is not too often)
  8. Thou shalt invest at least enough in your 401k to get the maximum company match and preferably at least 10% of your earnings.
  9. Thou shalt stay fully invested in low cost Index Funds and ignore the normal ups and downs of the stock market remembering, “Time in the market” beats “timing the market”.
  10. Thou shalt not borrow to buy a depreciating asset.
Last edited 24 days ago by Bob G
Scrooge_McDuck88
Scrooge_McDuck88
23 days ago
Reply to  Bob G

This list would be fine in stone…

parkslope
parkslope
24 days ago

Including A Random Walk Down Wall Street in the personal investing category ignores the fact that Burton Malkiel has had a long and distinguished academic career at Princeton and Yale.

R Quinn
R Quinn
24 days ago

As soon as I read “In the academic view, money is fungible, so there’s no reason to segregate funds in different accounts.” it confirmed my bias that academics don’t understand people and don’t live in the real world. No need? Yes need for most people. I put the common sense level of many academics at the same level as politicians.

Last edited 24 days ago by R Quinn
Nate Allen
Nate Allen
23 days ago
Reply to  R Quinn

I wonder if there are some academics who study human psychology or economics of human behavior who would have different views than the academics surveyed above?

Richard Gore
Richard Gore
24 days ago
Reply to  R Quinn

Of course, many people find it helpful to separate their funds into separate accounts for different purposes. However, it isn’t necessary from an economic point of view because yes money is fungible. That is a fact. I think fungibility of money is an important economic fact that may help people make some better decisions, like paying down debt rather than keeping excess cash reserves. The role of the academics is in part to help us understand what is an important economic distinction versus what we may do for psychological reasons.

TomandDeb Leigl
TomandDeb Leigl
24 days ago

Best part of the article……the last paragraph!!!!

“A final thought: Choi did identify one—and only one—area in which there was broad agreement between academics and popular authors. On the topic of mutual funds, nearly all agreed that index funds were a better bet than actively managed funds.”

Mik Cajon
Mik Cajon
24 days ago

Advising/teaching on ANY subject without actually having real world experience is a disservice to the student and society.

Last edited 24 days ago by Mik Cajon
zaduzopa
zaduzopa
23 days ago
Reply to  Mik Cajon

As we used to say in the Army: Those who can do something, do it. Those who can’t do something, teach it. Better to follow those who are doing than those who are teaching (unless, of course, the teacher is also doing it)

M Plate
M Plate
24 days ago

“Consumption smoothing” and pretending that all stock markets are created equal, are just 2 examples of academic disconnect with the real world.

Richard Gore
Richard Gore
24 days ago
Reply to  M Plate

Almost everyone engages in consumption smoothing to some extent. We borrow when we are young to buy houses and sometimes cars and then pay those loans back over time. We also save when we are working and spend that money later when we retire. Those are both common examples of consumption smoothing.

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