Who is right about your money: traditional economists or self-help authors?

Personal finance can be pretty confusing. How much should you save? How should you approach paying off your student debt? And what’s the deal with stocks, shares, mortgages and pensions? These high-stakes questions involve a lot of math and a lot of jargon, so it’s unsurprising that people turn to popular self-help books for guidance. These books typically offer relatively simple advice. But do they give good advice? The self-help industry is often criticized for spouting B.S. — can you trust it in the realm of personal finance?

Economist and finance professor James J. Choi was interested in whether popular finance books give the same advice as academic economists. He surveyed the 50 most popular personal finance books on Goodreads, including bestsellers such as Robert Kiyosaki’s Rich Dad Poor Dad and Dave Ramsey’s Total Money Makeover. 

He found that popular authors and traditional economic models sometimes agreed on what individuals should do to manage their finances, but at other times, they gave very different advice.

You may then wonder: who is right? You might assume that economics professors have more sophisticated perspectives than self-help authors: perhaps popular authors are mistaken and their suggestions are oversimplified or ill-informed. However, when we examine some of the differences between popular and academic advice, we discover that some academic economists and popular authors often give different suggestions because they apply different frames to the problem. 

In brief, academics in finance and economics who employ a traditional way of modeling human behavior, often known as ‘the rational actor model’ (which is most associated with neoclassical economics), are grounded in math and theory about optimal decision-making for rational agents. They are often trying to answer the question "what should the perfectly rational person do?" On the other hand, self-help authors’ recommendations are more focused on real human behavior (which is often far from rational) and are more in line with less-classical schools of academic economic thought (such as behavioral economics). 

Intriguingly, this framing difference sometimes causes the self-help gurus to give more helpful advice, whereas in other situations (or for other people), the neoclassical professors' advice is more beneficial. In this article, we'll follow the lead of Choi's analyses, explore how advice differs between self-help authors and traditional economists, and discuss what this advice implies for your own decision-making about your finances. And we will explore how self-help authors and neo-classical economics each sometimes gives useful advice, whereas at other times each gives potentially counterproductive advice.

Please note that nothing we say in this article is financial advice. It’s prudent to do your own research and to consider consulting a financial professional before changing anything about your own finances.

Savings

Should you have different ‘funds’ for different expenses?

Many popular finance authors suggest having different ‘funds’ or 'accounts' for your money that are each earmarked for different purposes in your life. For example, you might have an emergency fund, a retirement savings fund, a college fund for your kids, and separate funds for large purchases you’re planning to make, such as buying a house or car. 

Traditional economic theory doesn't recommend that people treat money differently depending on what ‘fund’ it's in: money is fungible, and financial decisions should take into account all your wealth, however it’s categorized. A dollar can equally easily be spent on your weekly groceries, your kids’ college fees, or a new car. It doesn't matter what account you happen to hold a dollar in: you should spend it on whatever is most valuable for you to spend it on. After all, it would be silly to use a dollar for a less valuable purpose merely because you'd previously earmarked it for that purpose.

However, many people find it both motivating and useful to have these separate funds: rather than putting money towards abstract “savings”, it gets allocated in advance towards something you care about, making more salient the link between your sacrifices today and your future house, your children’s education, or your comfortable retirement.

Putting money into your ‘retirement fund’ or ‘emergency fund’ may also make you less likely to spend it on spontaneous or frivolous purchases. In other words, it can help prevent lapses in willpower.

Using different accounts can also make it easier to tell whether you are on track to achieve goals. This makes it more straightforward to monitor your progress, which in addition to being motivational, can reduce your chance of making a mistake, and (for example) not having enough savings for an important expense.

Choi also points out that there are good economic reasons for separate funds: it can make it easier to adjust spending in preparation for big expenses. We often need to spend lots of money in a lump, for example when we’re moving house, getting married, or buying a car. Building up a ‘car fund’ or ‘marriage fund’ over months or years can help you work out how much to decrease your day-to-day spending in the time leading up to the big expense. 

Not all academic economic theories are blind to this. Behavioral economics research has suggested that people relate differently to money depending on how it is categorized: for example, gamblers sometimes report that if they win money gambling at a casino, they are more likely to spend it on something fun or frivolous than they are to spend their salary or retirement fund on those same items. In a 2019 experiment, participants were more likely to spend $10 on a theater ticket if they’d previously lost a $10 bill, compared to if they’d previously lost a theater ticket worth $10. This suggests that some people see themselves as having an implicit mental account that they were placing the theater ticket in, and that was ‘used up’ by the lost ticket.  

To a totally rational agent, every dollar is worth the same, no matter where it originated - and each dollar would be spent on whatever brings the most utility, regardless of what account it is stored in;  but to us humans, money that we make unexpectedly at a casino may not feel as "real" or "important" as money we made doing a grueling job.

So, what should you do? There’s no need to have separate funds for different expenses if that just adds complication to your life: money is money. And a perfectly rational agent wouldn't need to keep money in different accounts/. On the other hand, you might find that having separate funds for large expenses:

• Motivates you to keep contributing to the funds

• Reduces overspending, as you may be less likely to use money that's earmarked for something important

• Helps you know whether you're on track to afford important major expenses.

So whether or not you should keep different accounts for different uses of funds depends on whether you think these potential benefits would be useful to you.

How much of your income should you save at different points in your life?

If you make enough money that you’re able to save some of it, then you need to decide how much to spend and how much to save. As Choi reports, popular finance writers often suggest that you should save a fixed percentage of your income each month throughout your whole working (pre-retirement) life: for example, 10% or 15% of your income every month. Popular authors also tend to discourage taking on debt.

Academic economists, on the other hand, sometimes suggest something that is counter-intuitive to many: rather than saving a set amount of money (regardless of your income) or a set percentage of your income yearly, a rational person would instead practice ‘consumption smoothing’ over their lifetime. This would imply trying to predict how much money you’ll make over the course of your life (i.e., try to estimate the "expected value" of your future earnings) and then seeking to spend the same dollar amount each month of your life based on this expected value (rather than basing it on current income).

Since most people’s incomes rise as they go from young adulthood into mid-adulthood, if you followed this strategy, you’d theoretically save an increasing proportion of your income over this time. Some economic models even suggest that it pays to take on debt early in life, if your expected income after the debt outweighs the cost of borrowing. 

This proposal from economists might sound a bit crazy, or at least, surprising. Shouldn't you spend less money when you are young and have a lower income? Well, let's see where this proposal comes from.  

The idea of consumption smoothing is based on the fact that money has diminishing marginal utility. ‘Utility’ in economics refers to your preferences and desires being satisfied: basically, you getting what you want. ‘Diminishing marginal utility’ means that as you get richer, the same amount of money buys you less extra happiness. 

That is, on average, the first $5000 you spend satisfies more of your preferences and desires than the second $5000, which in turn satisfies more than the third $5000, etc. 

This makes some intuitive sense: if you're acting rationally, you’ll spend your first $5000 on the things that are most important to you — the things you anticipate will give you the most utility — then the next $5000 on things that are still valuable but not as much as your first-choice purchases, and so on.

Or consider: do you think a gift of $100 would bring more happiness to a student on a tight budget, or a well-off 50-year-old with a comfortable lifestyle? The student would probably value it more, right?

With this idea of diminishing marginal utility in mind, it makes sense to spend the same dollar amount each month rather than (as might be more intuitive) spending frugally in youth and lavishly in middle age when your salary is higher. You can frame this as your richer, future, 50-year-old self giving gifts of money to your poorer, younger student self. There’s usually a gain in total utility when a cash-strapped 18-year-old receives a gift of $100 from their wealthier 50-year-old uncle. If you take this logic to its extreme, it makes sense to transfer money from wealthier, future you to poorer, present you. And you can do this by saving less in youth — and perhaps even borrowing money — and then saving more in middle age.

It can be proven mathematically that a perfectly rational agent would follow this pattern, as long as a set of assumptions hold true, including:

• how much value you get from spending money (your ‘utility curve’) does not change over time

• you value your future utility as much as your current utility

• you can estimate your future earnings and the chance that you die each year with reasonable accuracy

• you can borrow money easily, even when young

• inflation won't cause the value of your savings to unexpectedly and substantially fluctuate

Unfortunately, some of these assumptions don’t usually hold in the real world. For example, in the real world:

• inflation makes it hard to calculate how much money you’ll need many years in the future (especially because it can't be accurately predicted how inflation will change over time)

• you might value the well-being of your future self differently from that of your present self. 

• your utility curve could change over time: for instance, once you have children, there may be purchases that give you greater utility per dollar that you didn't care about when you were childless.

• young people may not be able to borrow enough money to have the lifestyle they plan to have in their wealthier middle age; or, if they can, the interest rates might be prohibitive.

So, while consumption smoothing is an elegant theory, it probably doesn't work as actual advice, as it makes too many unrealistic assumptions. On the other hand, it may contain a nugget of wisdom: if you are confident your future self will be much wealthier than your current self, it may be reasonable for that to influence how you spend money today. On the other hand, it's easy to be overconfident on such predictions.

To return to the other perspective: popular finance authors, in contradiction to the consumption smoothing model, recommend saving a consistent percent of your income each month (before retirement), rather than spending a consistent dollar amount each month. Why is that? 

Well, first of all, many self-help authors argue that setting up regular savings payments in youth helps you establish saving as a habit, lessening the risk that you’ll be tempted to simply spend your extra cash when you have it. Saving a fixed percentage of one’s income may also be easier to automate and set up: you can work out what 10% of your monthly income is and set up a repeated transfer. It’s simple to put this money in your savings first — for example, straight after you get your paycheck — and then consider the rest of your money as available for you to spend.

Conversely, working out your expected income over the course of your life is extremely complex. It’s also riskier: what if you’ve miscalculated, or you’re unlucky and end up making far less than your predicted income?

So what should you actually do? The consumption smoothing model is provably correct as mathematical theory, but its assumptions are unrealistic. Perhaps it makes sense to use the consumption smoothing approach if you’re confident that you can reasonably estimate your lifetime income, it's easy to get low-cost loans, you don't expect substantial inflation, and if you think that your utility curve – the amount that money that can satisfy your preferences – will stay the same over time. But for most people, it may be wiser to simply save consistently throughout their pre-retirement life. The exact percent to save though - whether it be 5% or 20% - is up for debate, and will likely need to depend on your personal goals, current savings, current income, and expectations for the future. 

Debts

In what order should you pay off your debts?

Many people have multiple debts: for example, you might have student debt, a mortgage, and debts from multiple credit cards. If you're in that situation and ready to start paying off some of the debt, which one should you start with?

Many academic economists recommend that you pay off the debt with the highest interest rate first. A debt’s interest rate determines the amount you must pay each month per dollar of that debt, so higher-interest debts cost you the most every month. Therefore, it makes sense to get rid of the highest-interest debts first.

Choi reports that about half of self-help authors also recommend this, but others recommend a different approach, more in line with insights from behavioral economics: that you should pay off the debt with the lowest balance first (this is known as the ‘snowball method’). Popular author Dave Ramsey explicitly says that the snowball method isn’t about math, but ‘behavior modification’. If you start by paying off smaller debts (the reasoning goes), you’ll fully pay off individual debts more quickly, meaning that you'll completely eliminate one of your debts the fastest; this will motivate you and give you momentum towards paying off the others. 

The disagreement between (some) economics academics and (some) popular authors here might partly be because debts have a financial cost — their interest rate — but also a psychological cost. People may feel more psychologically burdened by having a greater number of separate debts rather than fewer, even if the total balance is the same. This means that paying off smaller debts as quickly as possible (to eliminate them completely) may be the best way to reduce their psychological burden, even if it’s not the most efficient way of reducing the financial burden.

Traditional economic theory makes assumptions about human psychology that have since been challenged. Herbert Simon won a Nobel prize in 1978 (in part) for proposing the theory of bounded rationality as an alternative to the traditional view of humans as completely rational. Based, in part, on his insights, the field of behavioral economics was born. The way of thinking about humans that is associated with traditional economic theory (sometimes teasingly called ‘homo economicus’, rather than ‘homo sapiens’) may show the best way to maximize utility for a perfectly rational agent, but it doesn't take into account the limitations and psychology tendencies of real humans. .

So what should you do when it comes to paying off debt? Well, it depends on your goals and beliefs. If you want to maximize your wealth over time, you may want to start by paying off higher-interest debts, regardless of the debt’s total amount. But it’s reasonable to want to get smaller, lower-interest debts out of your hair first if you find that motivating or you’d find psychological relief in reducing the number of distinct debts that you have. 

Should you build up savings while paying off debts?

33% of US households hold considerable (low-interest) savings even while holding high-interest debts. Why this happens has puzzled some economists: these debts cost their holders far more than the rate of return that most people make from savings, so they’d be financially better off putting those savings towards paying off the debt. In a sense, paying off high-interest-rate debts has a very high return, since it saves you a large amount of future interest. For instance, an investment that paid you a 20% return a year would be considered a fantastic investment: 20% is far in excess of the stock market's average return). Analogously, it’s a great investment to pay down a debt that requires you to pay 20% interest annually. 

So why is it common practice to hold money in savings even while in debt?

Partly, it’s because people need money for emergencies. Losing all of one’s money is really bad, and people are understandably very concerned about this risk. Going from $20,000 to $10,000 in savings is bad, but going from $10,000 to $0 is much worse (even though you've lost the same dollar amount in each case).

This is what’s known as ‘risk of ruin’ in gambling and investment: when making a bet, you should consider not just the chance that you’ll win the payout, but the risk that if you lost the bet, you’d lose all your money (or so much that you can't recover). You shouldn’t go to the stock market and gamble the entire contents of your bank account, even if you're confident that your odds of winning are better than 50/50. Similarly, not having any savings is risky, in a way that maintaining high-interest debt is not. A sudden unexpected expense, or a sudden drop in income, could leave you without enough money for something you really need.

Popular authors also tend to advise that if you’re in debt, you shouldn’t take on further debts. So to them, this is a reason to keep some savings: if you don’t have any savings, you might be forced to take on a new debt in an emergency.

Putting some money into your savings each month — even while you’re in debt — can help build the habit of saving. Many people find it motivating to see their savings grow, but are discouraged when they contribute large sums towards paying off a debt, with no visible, concrete benefit (even though paying down the debt will save them more in the long term).

So, what makes the most sense? Again, it depends on your goals and beliefs. If you only care about maximizing your financial returns in the long term, you’ll follow traditional academic economists’ advice to prioritize paying off high-interest debts. However, this means that you risk a sudden expense or drop in income preventing you from getting something you really need. So you may want to save enough to have a buffer, but beyond that prioritize paying off debts. 

Additionally, if you owe a lot of money, you may want to consider restructuring your debt (either by renegotiating with the entity you owe money to, or working with a third party that specializes in restructuring). Depending on who you owe money to and the economic environment, debt restructuring may reduce monthly payments, reduce the chance of you defaulting near-term if you're having a cash flow crunch, and may allow you to simplify multiple debts into one. On the other hand, restructuring can also come with risks: for instance it sometimes can have a negative impact on your credit score, can generate additional fees, can increase the total amount you pay throughout the entire life of the loan, and can open up the potential for fraud (if you accidentally work with an unscrupulous restructuring company).

Investing

Should you prioritize stock investments that pay dividends?

If you invest in stocks, you’ll sometimes earn dividends: regular payouts to shareholders. According to some self-help authors, investors should prioritize investments that pay out high dividends.

Choi doesn’t tell us why these popular authors suggest this, but it may be because it’s gratifying to receive money into your bank account on a regular basis from your investments: it feels like ‘free money’ and encourages people to continue to invest. The money is also essentially risk-free once it goes into your personal account, unlike the capital that’s tied up in the stocks, the value of which can go up or down over time, and may ultimately decrease. Finally, it could simply be that money invested in stocks doesn't feel like it's "yours" until you convert the money to cash, which the dividends are effectively doing for you. These insights are already acknowledged by some academics.

Other academic economists, on the other hand, subscribe to Miller and Modigliani’s dividend irrelevance theory and therefore argue that the amount of dividends that stocks pay out is irrelevant. On this view, stocks that pay out dividends don’t actually contribute more money to shareholders in the long run: any dividend essentially comes out of the stocks’ value, and the price of the stock already takes into account any expectations of dividend payments. So when you receive a dividend, it’s not the case that you are actually receiving more money; you’re just getting that money now instead of later. And, on top of that, if you have your money in stocks, you can always sell those stock shares to turn them into cash (usually within a few days or less). There is no need for the stocks to pay you dividends; you can simply turn the stocks into cash whenever you need cash.

The dividend irrelevance theory is debated among academics, with some pointing out that the theory assumes perfect capital markets, which don't exist in reality. Factors like taxes, transaction costs, and information asymmetry can make dividends relevant, in some cases.

If you’re a US citizen, there may be an additional reason to avoid high-dividend-paying stocks: dividends are sometimes penalized by the US tax code relative to holding stock (unsold) for a long period. So if you plan to hold a stock for years, you may be better off just selling it at the end when you're ready, rather than having that stock pay you dividends throughout that period. However, tax rates are complex and depend on a variety of factors specific to each individual.

Should you diversify your portfolio internationally?

According to academic economic theory, all else equal, a more diversified stock portfolio is better. When it comes to stocks, this implies that you should be diversified internationally (unless you have some reason to think that your own country's investments are less risky, and not lower returning, than the rest of the world's). The maximally internationally-diverse portfolio is to hold stocks from each country in proportion to the country’s total share of the world's public stock markets. If there is no a priori reason to prefer investing in some countries than others, by spreading your investment across the world you would be reducing your risk (through diversification) without reducing your expected return. 

In practice, most people have proportionally more stocks from their own country. Most self-help books by US authors do recommend that readers diversify their stocks internationally, but they tend to suggest a proportion of US stocks that is greater than the market share of the US.

Some popular authors don’t give a reason for this; others argue that foreign stocks are riskier. Others say that US stocks are sufficiently diversified anyway because of the fact that many US companies are multinationals or receive substantial revenue from other nations.

Some argue that there are good reasons to favor US stocks: over the past 20 years, US companies have done extremely well: you might expect that trend to continue if you believe that it’s related to facts about the US that are still true today.  

More generally, you might feel that you should invest in the countries that seem likely to have high economic growth in future while simultaneously having low risk. But, if it is well known that stocks from that country offer high expected returns with low risk, then many others would also be attracted to those stocks, which will drive up their prices and (hence) lower their returns. In other words, classical economic theory says that there’s no way to invest in international stocks with both high expected returns and low risk, unless you have some information that other market participants lack.

People may also simply feel more comfortable investing in stocks from their own country. They may be patriotic, and like to feel that their money is supporting their home economy. They may feel safer investing in familiar companies that they trust, rather than unknown international companies. Or they might be excited to invest in businesses that they themselves buy from, which are more likely to be businesses from their own nation. Finally, people may prefer stocks from their own country because they want to reduce exposure to foreign currencies. 

Conclusion: why do popular finance authors and traditional academic economists sometimes differ? 

There are a few patterns. Traditional academic economists (such as those who work in neoclassical economics) try to model how completely rational agents would behave. Of course, economists understand that real humans aren’t perfectly rational or capable of becoming perfectly well-informed, but many traditional economic theories are based on modeling people as though they are.  Popular self-help book authors, on the other hand, are less concerned with theorizing about how perfectly rational people would behave and more concerned with practical advice for real people, which means that they have to recognize and take into account the fact that humans don’t always act rationally, and that we’re sometimes missing crucial information. Their advice therefore involves workarounds for cognitive biases and for the fact that life is messy. This is much more in line with less-traditional economic fields such as behavioral economics. And this makes sense, but these workarounds can have significant downsides, and they may mean that you’ll lose money compared to the optimal theoretical strategy.

In particular, popular authors and behavioral  economists (who take into account psychological tendencies rather than using a rational agent model) understand that:

• People tend to do whatever is the default, and we’re better at avoiding lapses of willpower when we form habits (so it may make sense to automate your savings)

• The psychological burden of a situation can be larger than the economic burden (hence the ‘snowball method’ of paying off small debts)

• People may not be willing or able to do complex computation, and may find it easier to learn, remember and apply simple rules (so it may be easier to save a fixed proportion of your income rather than calculating your average future earning potential and smoothing consumption over time).

This may sound condescending, or like assuming people are stupid. But in some cases, traditional academic economists’ advice doesn’t seem to take into account people’s real-life circumstances, such as the fact that many people naturally want to increase their expenditure in midlife due to changing preferences over time, for instance when they have children. This needn’t be related to any form of bias. 

On the other hand, popular authors seem to simply give bad advice sometimes, such as when they advise people to prioritize stocks that pay out high dividends. And there can be real and substantial monetary costs to deviating from what economic theory tells us, such as when self-help authors suggest prioritizing paying down debts that are not the ones with highest interest. The closer to a "rational agent" you can be, the better the standard economic theory will usually apply to you.

We can see the recommendations of academic experts and practical advisors as complements to one another. Sometimes you may find the advice from self-authors will be the best for you. At other times, you may find it overly simplistic, or find that you don't need their behavioral tricks, and you can try to more directly model the behavior of what theory says a rational agent would do. Neoclassical economics provides a powerful theory that works well as guidance when we are able to approximate rational actors. Behavioral economics and popular self-help book authors (at their best) offer practical approaches that work well when we can't act like rational actors due to our limitations and psychology. Sometimes the assumptions of neoclassical do a good job of modeling the world, and sometimes they assume too much. Sometimes self-help books have really good advice, but then again, many self-help books say silly or even harmful things.

In all cases, it's up to you to apply discernment and a skeptical mindset in order to find what's helpful.