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July 27, 2023
How do you make financial decisions? Do you follow your gut? The advice of a YouTube financial guru? Would an economist who analyzes all the angles be the best source of truth? What about a Financial Advisor or Certified Financial Planner? A planning coach? Do you run the numbers yourself? What role does your understanding of behavior finance play into the decisions you make?
On an episode of the Freakonomics podcast, host Steven Dubner interviewed Yale economist James Choi. They discussed, “Are Personal Finance Gurus Giving You Bad Advice?”
Guess what? They all have something useful to say and the best outcomes will typically occur when you have sought information from a variety of perspectives.
Let’s explore the pros and cons of different sources of information.
Studies have shown that people tend to rely on heuristics and gut instinct for simpler and more routine financial decisions, especially when faced with time constraints or a lack of detailed information.
These heuristic-based decisions can sometimes lead to biases and suboptimal outcomes, depending on the knowledge base and emotional awareness of the decision maker.
Choi argues that economists can represent the objective truth for the best financial decision. While most economists are focused on macro economic issues, their scientific approach could be meaningful to personal finance questions.
Economists have a strong analytical background, enabling them to assess financial situations using data and economic principles. They typically base their advice on economic theories and empirical evidence, aiming to offer objective recommendations.
The downside to financial advice from an economist? The information won’t be personalized and it may be difficult to understand.
There are all kinds of financial gurus – personalities who hand out financial advice on YouTube, Instagram, and on radio shows & television. They are entertaining and can often give great actionable advice in easy to understand language.
The downside to advice from a financial guru? The problem is that knowing who to trust can be difficult. Not all gurus have the same integrity and expertise. More interestingly, Choi discovered that popular advice and rules of thumb do not always produce the best financial outcomes.
Choi and a team of undergraduate research assistants read and analyzed the advice found in 50 popular books on personal finance from financial gurus and compared that to economic theory. The result, a paper titled, “Popular Personal Financial Advice Versus the Professors.” He found “some pretty significant differences” in approaches to mortgages, debt repayment, spending vs. saving, investment styles, and more. (See below for more info.)
Professional advisors can absolutely provide great advice tailored to an individual’s specific goals, risk tolerance, and financial situation. It is what they do. The problem? They can be expensive and some might be overly focused on investments. Finding the right match for your personality and planning needs can be challenging.
Okay, we are biased. We obviously think that using tools is a GREAT way to make solid personalized decisions about your money.
Planning tools rely on a mathematical algorithm, providing objective results on the scenarios provided. Some tools are simple, with few inputs and heavy reliance on assumptions. Other tools like the NewRetirement Planner offer almost unlimited personalization. Users can try different “what if” scenarios to personalize their decision making and gain confidence and know how about the workings of their money.
A financial coach is not a certified financial advisor, but they typically have deep expertise in personal finance. Most coaches can not give financial “advice.” However, they can give you an objective perspective on financial planning decisions and help build confidence in your own decision making.
Different financial coaches will have vastly different approaches to how they work with you.
A behavioral finance expert is someone who specializes in the study and application of psychological and behavioral factors that influence financial decision-making. They combine principles from psychology, economics, and finance to understand how cognitive biases, emotions, and social influences impact individuals’ financial choices.
Many gurus and some financial advisors and coaches in fact use behavioral finance to help their followers with better decisions. Understanding behavioral finance can be incredibly useful to anyone making or helping someone make an optimal financial choices.
Morgan Housel is the author of The Psychology of Money: Timeless lessons on wealth, greed, and happiness. He argues that economics and mathematical models are not necessarily the best decision making tool. He told Dubner, “It [economics] is taught as a math-based subject where two plus two equals four and there is one right answer. In the real world, though, it’s not like that at all. It’s a much mushier topic. You know, people do not make financial decisions on the spreadsheet or on the chalkboard. They make them at the dinner table. And the gap between those two things can be ten miles wide. So it’s not that I didn’t learn anything useful about economics in college. It’s just that I was completely blind to the difference in how emotions and psychology and sociology, keeping up with the Joneses, how all those topics play into financial decisions that tends to be ignored at the academic level.”
Want to know more about behavioral finance? Try these resources:
So, let’s take a quick look at three of the financial questions covered in Choi’s paper and how different approaches can result in varied outcomes.
Economist Viewpoint: An economist would say that the best way to pay off debt is to focus payments on the highest interest rate debt. This will save you the most money.
Guru Point Of View: Many gurus (about half) actually recommend the snowball method of paying off debt. This entails paying off the debt with the smallest balance first. They recommend this because they feel that the success you’ll feel from paying off a debt, will propel you to keep paying down what you owe. Sure, you’ll pay more in interest over the lifetime of your debts, but you may be more likely to get them paid down.
Behavioral Finance Point of View: Do whatever works for you. Know yourself. Housel agrees with the gurus on this one. He says, “I would just say, how many people has Dave Ramsey helped out of debt versus the average academic economist? It’s a million to one. Even if it is wrong on paper and it makes economists wince, it’s practical in the trenches. It actually works.”
NewRetirement Point of View: Run scenarios for both options. See exactly how long it will take to pay off debt using each method and review your lifetime payments and net worth for each scenario. Consider what you can comfortably pay and come up with the plan that is right for you.
Economist Point of View: Economists widely believe in the concept of consumption smoothing. This is an idea about wanting to maintain a roughly consistent level of expenditures (in proportion to income) over your lifetime. So, when you are young and making less, you might save less and spend more of your income. And, when you are older and making more, you would spend less (as a percentage of income) and save more.
Guru Point of View: The gurus recommend that you start saving as young as possible and commit to saving a certain percentage of your income – no matter how much you are earning. The gurus believe that this creates the right habits for building wealth.
Behavioral Finance Point of View: Be aware of what you are doing and why.
NewRetirement Point of View: Run your own numbers and compare options. Do what feels right to you and makes sense in light of the financial model and your own goals. Do what makes you happy AND enables you to achieve the future you want.
Mental accounting is the practice of dividing money into different baskets. You might have one basket for vacation and another for retirement, for example.
Economist Point of View: Economists are not fans of mental accounting. Choi says, “Well, money is money is money. So if I have a dollar in my bank account, I should be using that dollar for its best use. If that means that right now, that dollar is best used for my vacation to Hawaii, then we should use it for that. And if the dollar’s best use is to buy school supplies for my kids, that’s its best use. What mental accounting does is it tends to draw these rigid boundaries where a dollar that’s being set aside for my Hawaii vacation, that can’t easily be used for some alternative purpose. And so economists would say it doesn’t really make sense to divide up your wealth into these rigid buckets.”
Guru and Behavioral Finance Point of View: Mental accounting makes a lot of sense to behavioral finance experts and gurus love it. Mental accounting can give you peace of mind and help you march toward multiple different goals and priorities.
NewRetirement Point of View: Do what makes sense for you. Use tools to help you see the consequences of different options.
The best financial advice typically combines objective tools like the NewRetirement Planner with personalized advice from qualified professionals such as financial advisors or coaches. Behavioral finance insights can complement the advice, helping individuals make better decisions.
Relying solely on your gut or following advice from non-experts may not lead to the most optimal financial outcomes. But, your emotions and motivations are important. Just always consider your own financial literacy, the complexity of your financial situation, and your comfort level in managing your finances when choosing the source of financial advice.
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