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James Choi: The economists will assume that you can just flip the switch on age 35 and suddenly you become a super saver, and the popular authors say, “Look, human psychology doesn’t work that way, and so it’s better to be consistent in your savings over time.”
Stephanie Kelton: Welcome to the Best New Ideas in Money, a podcast for MarketWatch. I’m Stephanie Kelton. I’m an economist and a professor of economics and public policy at Stony Brook University.
Charles Passy: And I’m Charles Passy, a reporter at MarketWatch.
Stephanie Kelton: Each week we explore innovations in economics, finance, technology, and policy that rethink the way we live, work, spend, save, and invest.
Charles Passy: Today we’re going to start in the studio of, well, actually another radio show.
The Ramsey Show: Katie’s with us in Dallas, Texas. Hi Katie, how are you?
Katie: Yes, I’m good. How are you?
The Ramsey Show: Great. How can we help?
Charles Passy: That’s a clip from The Ramsey Show. You might know it. It’s a very popular personal finance show and podcast with millions of listeners. In this clip, the listener, Katie, confesses to having racked up tens of thousands of dollars in credit card debt.
The Ramsey Show: What’d you spend the credit card money on?
Katie: Just transitioning over from one job to another, paying my way.
The Ramsey Show: Bull crap.
Katie: Got into debt and (inaudible)-
The Ramsey Show: You did not spend $27,000 transitioning from one job to another.
Charles Passy: Now, Dave Ramsey and his co-host give Katie the same advice they’ve given before, which he’s pretty famous for. It’s called the debt snowball. It means you pay off the smallest credit card debt first. The idea is that that will motivate you to keep going.
The Ramsey Show: You’re going to list out the debts from smallest to largest, so the smallest credit card debt to the largest one. We’re not looking at the interest rate. We’re not going to do math right now. We’re going to work on progress.
Stephanie Kelton: The Ramsey Show is just one example of how millions of people look for financial advice. The show says it has more than 18 million weekly listeners, and long before podcasts, many turned to books on personal finance for advice. The book, Rich Dad Poor Dad, by Robert Kiyosaki, has reportedly sold 32 million copies since 1997. Another, The Millionaire Next Door, by Thomas J. Stanley and William Danko, has sold more than 3 million copies. But what kind of advice are these popular authors giving? That’s something today’s guest has actually looked into.
James Choi: The genesis of this all was when I started teaching a personal finance class at Yale a few years ago. I was looking for some textbooks, and it seemed natural for me to look not just at academic textbooks, but the hundreds of popular personal finance books that are out there in the marketplace.
Stephanie Kelton: That’s James Choi, a professor of finance at the Yale School of Management.
James Choi: So I picked out a few, and I was reading them. It occurred to me that, wow, these authors are writing things that some of which I just disagree with on kind of an opinionated level and some of which I thought was just factually wrong.
Stephanie Kelton: Choi wanted to understand better how the popular advice differed from the corresponding advice from benchmark academic theories. That quest turned into a study called Popular Personal Financial Advice versus the Professors. It was published by the National Bureau of Economic Research in August. In the study, Choi looks at some of the most popular advice given in the top 50 personal finance books. We’ll get into a few of those topics, saving, asset allocation, and the best ways to pay down debt in a moment. But first, Choi argues that the popular authors are in fact more influential than the economists.
James Choi: While the most popular of these authors, they have millions and millions of viewers or listeners or readers, and if I can get 500 people to read one of my papers, I think that’s a pretty good reach that I’ve had. Often, academic researchers are talking to a fairly narrow audience. If we’re lucky, then the audience includes some policy makers who will implement some sort of legislation or policies or whatever. But speaking to the ordinary person, that’s not really what we do most of the time. It’s not what we’re even in the business of doing really. These popular authors, they’re in the business of trying to get themselves in front of eyeballs and listened to.
Charles Passy: A recent study published by the University of Bonn illustrates how popular authors might be influencing people’s money decisions. It found that exposure to Dave Ramsey’s radio show reduced household retail spending by 5.4%.
James Choi: So it’s no surprise that I think that these people are more influential just because they’re getting a lot more exposure than academic economists are. Now, some of them are influenced to a certain extent by the ideas that have come from the academy. So in that sense, they are an amplification mechanism for some of the ideas that we have.
Charles Passy: So you read 50 books on personal finance for this project. I’ve covered personal finance. I don’t know if I’ve read 50 books in my lifetime. What was it like going through all these books?
James Choi: Well, I’ll confess that I did not read every single word of every page from all 50 books. I had specified ahead of time which topics I wanted to cover in my survey. It was interesting because there are certain themes that come through. You see certain phrases even get repeated over and over again across these different books as you really see this stream of thought that runs through the mainstream of American personal financial thought, this notion of setting life goals, having positive thoughts, understanding what’s really important to you. None of that stuff actually made it into my paper because that wasn’t really in the scope, but it does give an insight into the American psyche and what people are looking for when they’re coming to these books. It’s not just about managing the money per se, but there is a sense in which they are looking for a better life and a peace of mind.
Charles Passy: The first topic Choi looked into is how much to save and how to do it.
James Choi: The popular authors are very big on consistency in savings rates. So over time you should be saving a similar amount as a percent of your income through thick and thin. You might call that smoothing savings rates. Academic economists would say that the way to go is to actually smooth your consumption, to have a consistent level of expenditure on yourself over time, more or less.
Charles Passy: In other words, economists don’t advise you to save the same throughout your life. They say when you’re young and not earning as much money, you can save less, maybe nothing at all. But then when you’re older and earn more money, you should really gear up on that savings rate.
James Choi: It’s just a more pleasant life to consume the same or a similar moderate amount in this year and the next year versus really scrimping and scrounging and struggling this year, but then overindulging next year. Now, for most people, their income in their 40s and 50s is predictably higher than it is in their 20s. If you were to save a consistent percent of your income in your 20s as you did in your 40s and 50s, you would be really living at a fairly low standard of living in your 20s and you would enjoy a considerably higher standard of living in your 40s and 50s. Economists would say, “Look, maybe you can smooth out that consumption over your life cycle and live a bit more comfortably in your 20s and more modestly than you could otherwise afford in your 40s and 50s.” What that would imply is that your savings rate would be relatively low in your 20s, and you would be a super saver in your 40s and 50s when at that point your income would be much higher and you could more easily save a large amount.
Charles Passy: Living comfortably through your entire life sounds pretty appealing. So why do the popular authors advise you to save a lot when you’re young and don’t have a lot of money? One reason is the power of compounding interest. Compound interest is like super interest. That’s because you’re not only earning interest on the principal, or the initial amount, but also on the interest that’s accumulating. Another reason besides that one, well, it’s kind of psychological.
James Choi: I think there is this notion that you build a certain discipline of saving, that you become a type of person who is frugal by consistently saving over time. That’s not something that’s really present in academic economic models. The economists will assume that you can just flip the switch on at age 35 and suddenly you become a super saver even though you have hardly been saving at all up until that point in life. The popular authors say, “Look, human psychology doesn’t work that way.” If you have been saving before, then you’re going to have really hard time saving a ton right now. So it’s better to be consistent in your savings over time.
Stephanie Kelton: Choi also looked at asset allocation, questions like how much money to put in stocks versus bonds or whether to invest in international stocks or not. In this case, the two camps are pretty aligned.
James Choi: I think that the popular authors and the academic authors for the most part end up in not dissimilar places but for different reasons. But at the end of the day, what are both camps saying? They say that, when you’re very young, so you’re in your 20s, you might want to be a little bit more conservative than you would be in your 30s simply because you have such a thin buffer of assets. So if something goes wrong and you need to draw down in your assets, maybe you don’t want to have as much risk in your portfolio as you would in your 30s or 40s.
Stephanie Kelton: What Choi is saying is that when you’re in your 20s, you might want to be a little more conservative because it’s likely that you have less money to work with when you’re that young.
James Choi: Then have a very equity-forward strategy through midlife, and then become more conservative in your asset allocation as you approach retirement. So there’s an area of a lot of agreement between those two camps in terms of the life cycle of asset allocation. I think there’s also a lot of agreement when it comes to actively-managed versus passively-managed funds. Both camps will say that index funds are really the way to go, and I think there’s a lot of data that shows that that’s a pretty good strategy.
There are things on the margins where I think that the two camps have differences. For example, on the value of getting dividends from your stocks, particularly as you are approaching or are in retirement, the popular authors are much more favorable towards dividends. Whereas the academic authors would say you don’t need to wait for that dividend check to come to finance your expenditure from your investments. You can just sell some of the stock that you have and actually pay a lower capital gains tax probably than what you are going to be burdened by if you got a dividend check and then had to pay taxes on those dividends. Again, I think that that’s probably a little bit more on the margins of things that impact the welfare of the individual investor. So I think on the broad margins, you do end up in somewhat similar places when you follow either camps of advice.
Stephanie Kelton: Recently we’ve seen a new wave of investment advice circulating on social media platforms like Reddit. What’s choice perspective on the rise of the retail investor in an age of cheap and accessible trading?
James Choi: There’s a very famous study, a very, very famous couple of studies from the 1990s that found that when individuals trade stocks, they lose tons of money, so this study by Terry Odean, Brad Barber cited all the time in the popular press. What is not as commonly known is that transaction costs were much higher in the early ’90s, which is when that sample period in the studies was taken from. Transactions costs have come down a lot since the early 1990s, and so it’s actually not nearly as costly to be trading in and out of individual stocks as it used to be. So I tell my students, even though you might have been taught that this stuff is really bad for you, it’s not as bad as it’s been hyped up to be.
Now, do I think that people should be trading in these individual stocks? No, I don’t because I don’t think that they have any information advantage. I do think that it causes them to be under-diversified. But in terms of, on average, do they lose a ton of money on these individual stock trades? I don’t think that they actually do lose a ton of money because it is so cheap nowadays to trade in these individual stocks. I think that where people do get really hurt, and there’s emerging evidence on this, is when they trade options through these platforms where there the transactions costs are very high, and there are not obvious ways in which you can get exploited in the options market because these are markets that are much more complicated to understand. So I think that’s where the real action is in terms of consumer harm or retail investor harm in the auctions market rather than in the trading on individual stocks.
Charles Passy: Coming up, how do the professors differ from the popular authors on strategies around how to pay off debt? That’s after the break.
Stephanie Kelton: Welcome back to the Best New Ideas in Money. Before the break, we talked to professor of finance, James Choi, about a new study where he looks at the advice given by the popular authors of personal finance books and how it stacks up against the advice from economists. So what about this question of how to best pay off debt? As we heard in the beginning of the episode, the popular Ramsey Show advises people to pay off their smallest credit card debts first and not the cards with the highest interest rate.
The Ramsey Show: What we started calling the debt snowball, and it’s a real tough metaphor to grasp. You list your debts smallest to largest, you pay minimum payments on everything, but you attack the little one with a vengeance.
Stephanie Kelton: Here’s James Choi.
James Choi: This is another area where I think the divergence between the popular advice and the academic advice comes down to a little bit of a theory about human nature and human motivation. The academics would say that this is a very simple math problem. When you are thinking about paying down debt, you should prioritize paying down the highest interest rate debt because that’s the most expensive debt you have, and that’s the way that you’re going to get the most dollars at the end of the day to spend on yourself.
A lot of the popular authors say, yeah, that might be correct mathematically, but there is something that you’re forgetting, which is the motivation angle. If you don’t get some quick wins early on, you’re just going to give up and not complete your debt pay-down plan. So what you should do, instead of prioritizing paying down the highest interest rate debt that you have, is to pay down the lowest balance debt that you have. By zeroing out a debt account, you’re going to feel good about your progress, and that’s going to power you through to the end of your debt payment plan.
I actually have not seen evidence that the debt snowball is in fact more motivating and more successful at the end of the day than the other strategy, which the popular authors call the debt avalanche strategy where you prioritize the highest interest rate debt. I would love to see better evidence on this. At the end of the day, I do think that the best diet is the one that you can stick to. So if, indeed, the debt snowball helps you stay motivated to pay down debt, then yeah, you should go for it. It’s just that I’m not convinced at the moment that it is in fact more motivating for people.
Charles Passy: What was the worst piece of advice that you found among the popular authors, and why was it so objectionable?
James Choi: Well, there are some authors that recommend get-rich-quick sorts of strategies where you will buy real estate using a ton of debt, and you flip it for a big profit later on. That works great when real estate prices are rising, but of course, real estate prices can fall, too, and that can leave you in bankruptcy. So I think that that’s the most irresponsible advice that I saw.
I think where the popular authors may actually end up being right is more on the savings margin where you start getting into these questions of, is it the right thing to do to establish the discipline early on in life of saving even though that means that you’re really crimping and scrounging in your 20s? It just makes you into the type of person who’s frugal and lives within their means, and that keeps you out of trouble in your 30s, 40s, 50s and beyond versus trusting yourself that you’re going to be able to flip on that super saver switch in your mid-30s and rocket your way into a secure retirement.
That’s something that I don’t think that anybody really knows. It very well may be that going with the popular authors on the savings end and then on the debt repayment end to get those quick wins, to do the debt snowball, maybe that’s the diet that works for you. At the end of the day, going along with this diet analogy, the Atkins diet or the Mediterranean diet or what have you, there are a lot of diets out there that are pretty reasonable. None of them may be the ideal diet. But the best diet is the one that’s pretty reasonable that you can stick with.
Charles Passy: I’ve got to say, you sound like my cardiologist now. He’s like, “Just lose some weight. I don’t care whatever method you use.” I think one of the things you’re kind of saying here, and correct me if I’m wrong, is that sometimes these popular authors will espouse ideas that sound right and that may work for people, but some of this hasn’t been battle-tested.
James Choi: I think that there is a real lack of evidence here, and I think that I blame the academic economists here. We should have been researching this stuff. This is pretty important material. What is the best way to get people to pay down their debt? What is the best way to keep people motivated to stick to a reasonable savings plan? We just haven’t been researching it, and that’s why there is no evidence. We have kind of abandoned the field to these popular authors where they have their lay theories, their intuitions for what the right thing to do is. I would love to see more research to see, does any of this stuff actually work? Because on our end, we have just been mostly preoccupied with thinking about, what is the right thing to do if you have perfect self-control and you don’t get discouraged and you can stick to your plan? I don’t think that most of us think that human beings are like that.
Stephanie Kelton: Thanks for listening to the Best New Ideas in Money. You can subscribe to the show wherever you listen to podcasts. If you like what you heard, please leave us a rating or review. If you have ideas for future episodes, drop us a line at [email protected]. Thanks to James Choi. To learn more about personal finance strategies, head to marketwatch.com. I’m Stephanie Kelton.
Charles Passy: And I’m Charles Passy. The Best New Ideas in Money is a podcast from MarketWatch. Melissa Haggerty is the executive producer. The producers are Katie Ferguson, Michael McDowell, and Mette Lützhøft. Jeremy Banks is our news editor, and Tim Rostan is the executive editor for MarketWatch. The Best New Ideas in Money theme was composed by Sam Retzer. Stephanie Kelton is an economist and a professor of economics and public policy at Stony Brook University and not part of the MarketWatch newsroom. We’ll be back next week with another new idea.
