Who to listen to for financial advice
Popular financial authors face off against academic experts
The beginning of a new year is often a suitable time to seek financial advice, particularly since many individuals found it challenging to maintain their monthly budgets in 2022 and it is likely to be similar for 2023. What, then, is the most effective strategy for building wealth and from whom should one seek such advice?
One potential source of information is Robert Kiyosaki and his book, Rich Dad Poor Dad. In it, Kiyosaki promotes the idea of acquiring assets that generate income, such as rental properties, as opposed to the conventional approach of obtaining a good education, securing a stable job, and saving money. With over 40 million copies sold worldwide, it is evident that Kiyosaki's book has been widely accepted and has made him a multi-millionaire. Surely 40 million readers can’t be wrong?!
But is Kiyosaki’s focus on real estate indeed the best financial advice? One criticism is that the book is not based on empirical evidence, as many examples in it are derived from Kiyosaki's personal anecdotes and lessons learned from his (imaginary) wealthy friend's father and his own father's shortcomings. And what about the myriad of other financial advice books on the market, books like Thomas Stanley and William Danko’s 1996 classic The Millionaire Next Door (number 1 on Goodreads’s list of best personal finance books), or Dave Ramsey’s The Total Money Makeover (number 3 on Goodreads), or Vicki Robin and Joe Dominguez’s Your Money or Your Life (number 4 on Goodreads), or Ramit Sethi’s I Will Teach You to Be Rich (number 5 on Goodreads)? Few of them recommend focusing on real estate; instead, they advocate other ideas, often ones that contradict the conventional views of financial economists.
Let me give one example. Almost all economists agree that paying off your personal debt with the highest interest rate is the sensible thing to do. But some books, notably Dave Ramsey’s, argue that this is not the smartest move. Instead, he advocates paying off the smallest-balance debt first. The idea is that this motivates you to continue paying off your debt, changing your behaviour.
Just how different popular financial advice is from the consensus view is not something economists have paid much attention to. But a recent paper by James Choi, a finance professor at the Yale School of Management, in which he analysed the 50 most popular personal finance books (on Goodreads), suggests that popular opinion can be quite different from academic consensus. And this has important implications because millions of people are more likely to take their advice from a popular book than from an academic paper.
What are the main differences between popular advice and academic consensus?
When it comes to investment advice, popular financial books tend to recommend investing in high-dividend stocks, while the academic consensus is that high-dividend stocks are usually to be avoided. Popular books tend to recommend holding some money in cash for short-term expenses, while academics recommend investing such money in conservative assets. Popular books tend to recommend holding some international stocks, but less than in proportion to their global market cap weight. Academics would advocate holding international stocks in proportion to their global market cap weight. Finally, popular books tend to recommend holding value stocks and small stocks, while academics are ambivalent about holding these equity types.
Are there any similarities between the two groups? One clearly stands out: both popular authors and academics recommend staying away from active mutual fund management, investing only in passive index funds.
One of the biggest differences between popular books and the academic consensus is about saving. The standard model in economics is one of consumption smoothing: when you begin to earn your first salary in your early twenties, you have many expenses and a low income. You will therefore dissave (ie borrow money) to pay for your expenses. As your income increases, you will have more available at the end of the month and begin to pay back your loans and, once that is done, save. By the time you have retired, you will have a nice pool of savings available to continue at the same level of consumption that you had in your twenties.
That, at least, is how it is supposed to work in theory. But popular financial authors disagree. Many – 32 of the 45 books that Choi includes in his study – stress the importance of starting to save immediately. They provide two reasons for doing so. First, the magic of compound interest. The idea would be that you forego some of your consumption early in your life to reap the rewards of higher accumulated wealth later. Other authors emphasise having a safety buffer. And others, again, advocate having a dedicated saving percentage, like 10 or 20%, regardless of life circumstances. It is this discipline that many authors stress as vital to financial freedom.
As Choi explains, these findings should force economists to reflect on the relevance of their models. ‘The discipline argument is almost always missing from economic models of optimal saving – a potentially important oversight.’
What is clear is that the best advice from economic theory is not always the best advice in practice. Financial advisors might take into account the average person’s inability to stick to a financial plan, for example, something that academics would rarely consider. We are not all homo economicus, maximising utility every instant. Behavioural economists have shown how emotions can affect our decision-making and lead us to make seemingly irrational decisions. Popular financial advisors understand this psychology better than financial economists at present.
The takeaway from this comparison is that both popular financial advisers and economists can gain valuable insights from each other. While popular financial advisors can benefit from incorporating the advanced analytical techniques of economists to evaluate the effectiveness of their strategies (as real estate investments may not always provide the highest returns), economists can also gain from incorporating the practical perspectives of popular financial advisors into their theories.
What does this mean for you and me? Simple: Make sure to invest in a portfolio of views. Do your homework by reading more than just one personal finance book and following more than just one financial expert. In short, just as with your asset portfolio, don’t put all your eggs in one basket.
An edited version of this article was first published on News24. Photo by Jodie Cook on Unsplash.
A post on the high fees of South Africa's asset managers and how they never (6% of the time) beat the market would be a great addition to this post!
https://www.spglobal.com/spdji/en/documents/spiva/spiva-south-africa-year-end-2021.pdf
Especially against the comparatively risk-free/ high returns of SA Retail Bonds.