Please Soften the Rules of Thumb

Financial planning advice should be adjusted

Olivia Maguire, a newly minted CFP, is off and running at her new job. Passed the Series 7 exam and kept even keel during a good dose of corporate DEI training. Maguire is the latest boutique financial planning group addition and was asked to field a client question. “My daughter just graduated from college in June, and her new job will pay her $6,000 monthly. How much should she be saving?” Maguire writes: “$600 is a good start; 10%. That is common and will help her build a savings habit.” The Lemming Effect is never too far away.

The adoption of untested ideas perpetuates untested ideas. Personal finance books are replete with recommendations that need thoughtful reassessment in modern times. Does it make sense for somebody in their 20s to save 10% of their income? Why aren’t more households asking if that is always a good idea? How about the cited recommendation that the percentage equity in your investment portfolio should be 100% less than your age stated as a percentage? Easy to calculate, and that may be the point, but what does a 101-year-old grandmother with a $10 million portfolio do with that advice?

James Choi is an academic at Yale who has a forthcoming paper in the Journal of Economic Perspectives that attempts to understand the substance of conventional personal finance book writers in the most professional of terms.¹ Choi’s research starts with the top 50 personal finance books based on their Goodreads rank, then catalogs the prevalence of a few standard ideas among these writers. The authors may be familiar with Kiyosaki, Orman, Ramsey, Stanley, Danko, etc.

Choi is undertaking a serious approach to understanding the basic personal finance how-to recipes offered by personal finance writers to their millions of readers. Entitled “Popular Personal Financial Advice versus The Professors,” Choi confronts the conundrum of the deep market penetration of the popular press ideas about personal finance topics in light of what we know about personal finance decision-making today. One of the motivations for Personal Finance Economics was generated from the same curiosity. Why in the world do personal finance “experts” not have a foundation of knowledge underlying their recommendations? Why are personal finance consumers satisfied with receiving the same recommendations? Oddly, households always ask the same questions, “Remind me, what is that savings rule of thumb?” even though the boilerplate answers are omnipresent.

Choi’s research scribes a circle around popular ideas, most of which are captured by the statements below:

1. “Pay yourself first” and “contribute 10% of your income to a retirement plan.”

2. “Allocate assets to an emergency or reserve fund.”

3. “The % stocks in your portfolio should increase with your time horizon.”

4. “Focus on paying off smaller amounts of debt first: the snowball effect.”

5. “It is o.k. to hold higher interest debt while also holding lower return assets.”

6. “Adjustable rate mortgages are too risky.”

There will be more to Choi’s research as it develops, but he tabulates and reflects on the differences between pervasive financial advice and the current state of knowledge. Choi’s academic view responses are noted by (AV).

1. “Pay yourself first” and “contribute 10% of your income to a retirement plan.” AV: Savings is an outcome, not an input into a household financial plan.

2. “Allocate assets to an emergency or reserve fund.” AV: Money is fungible, but psychologically, earmarking funds may be valuable, too.

3. “The % stocks in your portfolio should increase with your time horizon.” AV: When configuring a portfolio, remaining human capital plays an important role.

4. “Focus on paying off smaller amounts of debt first: the snowball effect.” AV: Payoff high-interest debt first.

5. “It is o.k. to hold higher interest debt while also holding lower return assets.” AV: Payoff debt with assets when the debt’s after-tax interest cost is higher than the after-tax returns from assets.

6. “Adjustable rate mortgages are too risky.” AV: ARMS handle inflation risk, but not preferred if interest rates are already low.

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To Be Fair

Life-cycle economists and financial economists spend their professional lives defending their ideas, and they can be a cocky lot. Ideas are generated from what we observe but don’t know much about. There is an innate and humble inquisitiveness in the academy. Choi acknowledges that while developed knowledge exists contrary to many popular personal finance ideas, the very persistence of the popular ideas and behaviors may add information to some academic puzzles.

Popular press writers’ bias toward discipline and habit is their antidote to an intrinsic weakness assumed to afflict individuals who would otherwise consume too much money while young. There is no general answer if you wonder what “too much” is. Still, an economic habit may be beneficial, but it is hard to understand empirically. In a laboratory setting, structuring an experiment to track a discipline that creates a savings habit over time with a measurable economic outcome in a large sample experiment is difficult. But, let’s suppose there is support for the hypothesis that disciplined savings do cause households to have higher economic outcomes toward their later years. Planners would have to weigh the prospects of longevity, interest in retirement, an interest in leaving a bequest, and other end-of-life planning against the costs imposed by savings.

Moreover, required near-term savings implies fewer or no family vacations, a B-level education for the children, etc., and, in general, a lower living standard during those savings years. And, of course, all those single-person households would be crazy to create a pot of money that floats away at death to a faraway leaf on the family tree.

Common Ground

Not all is inconsistent. Choi finds there is mostly agreement between personal finance writers and our developed knowledge on the better ’ better value and performance over their actively managed counterparts. He attributes this finding to the conceptual difference: “Statistics on average performance and performance persistence are straightforward to calculate, easy to understand, and widely publicized.” I will throw Burton Malkiel’s “A Random Walk Down Wall Street” into the mix to help with a shared understanding of what works in investing. It is in the top 50, and I believe his research and writing has had an effect.

Education and Bad Habits

This semester, I have special (and captive) sets of SMU life-cycle economics students who are taught many economics-based financial planning principles. I asked them to review last week’s Substack Q&A to prepare for a quiz. I received this question and offered my response.

“What percent of a recent graduate's salary should be invested, and what should be saved (if anything).”

Yes, the students knew the question was coming.

They offered the correct answer plus three versions of the advice many of the popular writers offered. Potential answers are in the left-hand column, and selected choices by my students are tabulated.

About 20% of the class actually missed the question. Rival TCU was coming to town for the “Battle For the Iron Skillet,” I assume errant students had not studied, just relying on what they had heard at the dinner table or from others.

Like the faithful Olivia Maguire, education may be important, and less “lemmingness” is a good practice. Let’s hope Professor Choi’s work receives more exposure among financial writers and subsequent debate and input.

1. Choi’s work may be found here.