Personal finance

Money Saving Tips: Economists vs. Personal Finance Experts

Good news, young spendthrifts. You can probably ignore popular personal finance advice that you should always save some portion of your income.

A new working document by James Choi, professor of finance at the Yale School of Management, explores how popular personal finance advice — such as the directive to save early and regularly — stacks up against academic research from economists.

Choi has read nearly 50 of the most popular personal finance books of the past decade, including one by Robert Kiyosaki. rich dad, poor dadby Ramit Sethi I’ll teach you how to be rich and three titles each from finance celebrities Dave Ramsey and Suze Orman.

Choi found that, for the most part, the strategies that economists call optimal differ from the advice given in popular personal finance books.

This is especially true when it comes to money saving tips. Conventional wisdom says that you should save a fixed portion of your income each month, no matter how much you earn or where you are at in life. Of the 50 books in the study, Choi found that 21 recommend saving a fixed percentage of money that stays the same with age. Economists call this a “smooth” savings rate.

Most of these books argued for a savings rate of between 10% and 15%, while a few recommended rates around 20%. Personal finance writers like the idea of ​​setting a constant savings rate because it helps people build good habits and lets them start taking advantage of compound interest sooner rather than later. But economists say the advice is wrong.

How much should you save in your twenties?

There’s a simple reason economists say a steady savings rate isn’t necessarily a good idea: you don’t earn and spend the same amount of money at all stages of your life, so you don’t need to force yourself to save the same. amount at each age, whatever.

“Because income tends to be hump-shaped with age,” Choi writes, “savings rates should on average be low or negative in early life, high in midlife, and negative during retirement”.

In other words: when you’re younger, you probably don’t make a lot of money and your expenses tend to be relatively high. During this period of your life, it is natural to save less (or not at all), with the idea that you will make up for it by saving more later.

Most people enjoy higher incomes in middle age. This is when it makes sense to increase your savings rate. After you stop working, the ratio will change again, and you will spend those savings.

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Choi found similar flaws with popular personal finance advice on investing, taking out a mortgage, and more.

For example, many experts recommend the so-called “snowball method” when paying off debt. The strategy is to pay off your smallest debt first, then pay off the next one and so on. Proponents like Dave Ramsey say setting a pattern for success and being able to see your open accounts disappear early is motivating.

However, economists would say that the best method to tackle debt is to start with the loan with the highest interest rate, regardless of the balance, because this strategy would result in the lowest net payment. .

Emotional and personal finance advice

Choi acknowledges throughout his article that the cold, purely economic approach can fail in the real world. Authors like Ramsey often talk about motivation and habits. They emphasize the role emotions play when it comes to money – it’s the ‘personal’ aspect of personal finance. Academics, on the other hand, tend to have a more analytical and unbiased view.

In his article, Choi lends some credence to the fact that humans are, well, human. We are creatures of habit and sometimes make decisions with money that are not in our economic interest.

He quotes David Chilton, author of The return of the rich barber, which discusses the downsides of giving up savings when you’re young. The method “rarely works in the living room,” writes Chilton. “First, costs have a funny way of never stabilizing. Second, most people won’t be able to go from nothing on the sidelines to being super-savers in a jiffy. Psychologically, that’s just not realistic.

So while it’s not strictly necessary to save money consistently when you’re young, it can be easier to save later in life. It’s all about balance.

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