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 Door, Rich Dad Poor Dad, A 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.
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.