Are Personal Finance Gurus Giving You Bad Advice?

Hey there, it’s Stephen Dubner. Before we get to this week’s episode, we need your help with a future episode. Even if you don’t know the book (or the movie) — even if you didn’t know there was a book (or a movie) — you probably know the word: “moneyball.” That was the title of a book, published in 2003, by Michael Lewis. The subtitle is “The Art of Winning an Unfair Game.” It tells the story of a baseball executive, the Oakland A’s general manager Billy Beane, who realized he couldn’t compete with the big budgets of the bigger teams, so when it came to assembling his roster, he put his money on smaller bets, smarter bets, statistically sound bets. That’s what “moneyball” has come to mean today, even to millions of people who don’t know a thing about baseball. Moneyball means using data to identify advantages that others might miss. Next year will mark the 20^th anniversary of Lewis’s book — so we’re going to interview him for an episode of our Freakonomics Radio Book Club. And this is your invitation to go ahead and read Moneyball, or re-read it — and if you have questions you’d like me to ask Michael when we interview him, send them to radio@freakonomics.com, subject line “moneyball.” Thanks in advance — and now, on to today’s show.

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I’ve got a question for you today, a personal question. It’s about something you may not be so comfortable talking about. Let me give a little background first. Years ago, I was writing a book about the psychology of money. I was going to call it Money Makes Me Happy (Except When It Doesn’t). But I ended up putting that book in a drawer when I met Steve Levitt, an economist at the University of Chicago, and instead we wrote Freakonomics. That’s turned out pretty well. But the money curiosity never left me. I’ve always been intrigued by how we think about money — or, maybe more accurately, how we fail to think about money. It is one of those topics (like sex and religion and politics), that is often driven less by thoughtful consideration and more by emotion. Money is so versatile, so central to our daily decision-making, that we attach all sorts of emotions to it — excitement, fear, lust, regret. It’s hard to name an emotion that doesn’t get attached to money. And this can make money hard to talk about. In some cases, even taboo. Today, I’d like to put aside that taboo. And start with a simple question: where do you get advice about money? Here’s how some of our other listeners answered that question:

Sarah: I usually get it from YouTube. There’s a channel called The Financial Diet that I really enjoy.

Andrew HODNETTE: Mainly through financial podcasts. So, like, The Money Guy Show, Afford Anything.

Aamil SARFANI: Ray Dalio’s “How the Economic Machine Works.” It’s a YouTube episode on his channel.

Sarah McDOUGAL: I actually started a group with my female friends and colleagues. We call ourselves Purse Strings as kind of a joke, and we meet every one to three months to just talk about financial topics, share our strategies. 

Matthew SCHAPIRO: When you’re younger, you get it from parents and friends. As I get older, rely more on financial websites.

Winela KULMAN: Honestly, I get all my personal finance advice from my dad because he is almost never wrong with this kind of thing. 

You’ll notice none of these listeners told us they get their money advice from a C.F.P., a Certified Financial Planner. Perhaps this isn’t surprising: there are fewer than 100,000 C.F.P.s in the U.S., versus nearly 130 million households. So even though financial advice seems like something you should be willing to pay for, most people aren’t. But there’s another place where no listeners told us they get money advice: from economists. Why is that? Economists must have a lot of advice about managing your money, right?

James CHOI: Economic theory doesn’t really have a lot to say about that right now, which is kind of a shock and a scandal, I think.

There is at least one economist who does have a lot to say. And he would like you and me to listen to people like him rather than turn to the podcasts and YouTube channels and books written by popular money advisors.

CHOI: There are some pretty significant differences between what economists would recommend versus what these popular authors would recommend. 

Today on Freakonomics Radio: a smackdown between the economists and the popular-finance experts — with your money in the middle.

Morgan HOUSEL: How many people has Dave Ramsey helped out of debt versus the average academic economist? It’s a million to one.

Also, we’ll hear your biggest money mistakes. All that, starting right now.

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I’d like you to meet James Choi.

CHOI: I’m a professor of finance at the Yale School of Management. 

Choi has a Ph.D. in economics. And economists have a lot to say about money when it comes to macro stuff — fiscal policy, monetary policy, corporate finance, investment strategies, things like that. But when it comes to micro stuff — questions about money that you or I might have, what’s called personal finance or household finance — most economists have little to say. Why is that? I asked James Choi if the kind of person with the brainpower to do big macro thinking may just consider household finance déclassé.

CHOI: I don’t think it’s déclassé, but I think it’s a complicated problem that may end up giving you a messy solution, which is never quite intellectually satisfying. There is this intellectual infrastructure in, say, macroeconomics. And so we’re going to study business cycles, we’re going to study inflation, we’re going to study unemployment. And so there are conferences, there are grants, there are journal articles. There’s this momentum that’s created by the intellectual infrastructure that causes scholars to produce papers in that area. Now, this field of household finance, it’s been around for a while, but it was only really named as a field in the last 15 or so years. Maybe in the next ten years there will be a lot more smart people that start thinking very seriously about this sort of question.

Choi recalls hearing another theory, from an elder statesman in his profession, about why most economists don’t care about household finance.

CHOI: He hypothesized that there was this division of labor in the early 20^th century when business schools are being set up, where business schools were for men, and they were going to go to corporations and they were going to manage corporate finances and they were going to do asset management. And so the fields of corporate finance and asset pricing, these were serious fields that were worthy of study in business schools. And the household finances, the personal finances, that was women’s work. 

Choi himself got interested in personal finance because he’s also interested in behavioral finance.

CHOI: When you actually look at what people are doing with their financial lives, you realize, “Hey, they’re doing some weird stuff,” and you can’t help but go in a behavioral direction.

So he set out to design a personal-finance course to teach, at Yale.

CHOI: And I was looking for a textbook. It seemed natural to look at some of these popular books that were out there because there’s so many of them, to see what do they have to say, and maybe they have some very practical, on-the-ground advice. And I looked at a few of these books and I thought, “Wow, some of this advice is either stuff that I disagree with or stuff that I think is flat-out wrong.” But I had to teach the course, the semester was starting, and so I settled on a book, and I kind of went on my way. 

Stephen DUBNER: What was the book you settled on?

CHOI: Popular Finance for Dummies. It’s actually a surprisingly good book despite the title. 

The title is actually Personal Finance for Dummies, by Eric Tyson. But let’s not read too much into the fact that the one popular-finance book that an economist deigned to teach, he gets the title wrong. Anyway:

CHOI: So that planted the seed of this idea that maybe it would be interesting to do a more systematic survey of what these popular authors were writing. 

For this systematic survey, Choi selected the top 50 personal-finance books as measured in 2019 by the book site Goodreads.

CHOI: And so that started this multi-year project where I had a team of undergraduate R.A.s read these 50 books and create their own taxonomy. And then as I was trying to pull all that together, I just ended up feeling that I needed to read these 50 books myself and do some close textual analysis of the relevant passages. And that’s kind of where the paper ended up, at the end of that entire process.

“The paper” Choi is referring to is something he recently published; it’s called “Popular Personal Financial Advice Versus the Professors.” In it, he examines the advice given in books like Rich Dad Poor Dad by Robert Kiyosaki; The Millionaire Next Door, by Thomas Stanley and William Danko; and Women & Money by Suze Orman. These are books that sell millions and millions of copies. Now, some popular finance books are written by Certified Financial Planners, or at least distill the best practices that C.F.P.s offer; but many are not. Many pop-finance authors also host podcasts, or T.V. and radio shows — Dave Ramsey, for instance, has a radio show that is said to reach millions of listeners each week. A good research paper by an economist, meanwhile, might get a few hundred downloads, maybe a few thousand if they’re lucky. Let’s face it: The Money Book for the Young, Fabulous & Broke, by Suze Orman, might sound a wee bit more accessible than an econ paper like “Optimal Life-Cycle Asset Allocation: Understanding the Empirical Evidence.”

CHOI: From the economists, you really are looking at arcane journal articles, full of equations and math. There is, as far as I know, no or very few books that are written by academic economists that are really trying to speak to the common person. 

But what if the economists have better financial advice than the authors of these books? Wouldn’t that be worth knowing? Choi set out to compare the advice from these books to similar advice from the economics literature. He focused on a set of typical issues, like home mortgages, debt repayment, spending versus saving, investment style, things like that. And he found what he calls “some pretty significant differences” between the economists’ recommendations and the advice in the books.

CHOI: Now, often these differences come about because the authors are trying to make concessions to human frailty. So either failures of willpower, of motivation, or there’s this interesting notion, especially in the savings domain, about building a discipline where if you habitually save even when you’re young and you’re relatively low-income, that’s going to make you into the type of person that is able to save and live frugally in your middle age, in your older years as well. And that’s something that’s completely absent from economic models, this kind of Aristotelian notion of building virtue by the things that you do. 

DUBNER: But it seems that economists offer the opposite advice — that you want to smooth your consumption over time, not your savings.

CHOI: That’s right. So you should save relatively little when you’re in your twenties, then when you’re in your late thirties and forties, you should become a super-saver. You know, flip that switch and be saving large percentages of your income.

DUBNER: And the reason that’s better is why?

CHOI: It’s actually a very simple conception of human joy and sorrow, which is that the fourth piece of pizza that you eat is less pleasurable than the third piece of pizza you eat. And the fifth piece of pizza you eat is less pleasurable than the fourth piece of pizza you eat. And so that leads to the very common recommendation from economic theory that you should have a pretty consistent level of expenditure from year to year. Because it just doesn’t make sense to have ten slices of pizza tomorrow and no slices of pizza today. The technical term for that is consumption smoothing. Now I think in reality, the relationship between how much we spend on ourselves and how much joy we get changes over time. Maybe next year you’re getting married, and it will bring you a lot of joy to have a blowout wedding. And so you spend 10, 20, $30,000 more than you otherwise would have. And that’s not at all a mistake. That’s something that you should do. Or, you know, you’re single, you’re young, you’ve just graduated from college, you’re living in Manhattan. What a glorious thing that is. And so maybe it is optimal for you to spend more than you otherwise would in those years. And then you know that in five years or so, you’re going to move back to the low-cost-of-living Midwestern town that your family’s in. And so it just doesn’t make sense to have a consistent level of spending across those years.

But generally, Choi says, economic theory would suggest we smooth our spending across our lifecycle. Most popular-finance books, meanwhile, recommend the opposite: that instead of smoothing spending, you should smooth your saving. In other words, you should put aside the same percentage of your income every year, no matter how much (or how little) you make. One popular book in Choi’s analysis is called The Index Card: Why Personal Finance Doesn’t Have to Be Complicated. It was written by Helaine Olen, a journalist, and Harold Pollack, who is a professor (at the University of Chicago), but not in finance or economics; he works in public health policy. Pollack and Olen argue there are just 10 simple rules to know about money, all of which can fit on a single index card. Rule No. 1, for instance: “Strive to save 10 to 20 percent of your income.” A few years ago, we interviewed Pollack for an episode called “Everything You Always Wanted to Know About Money (But Were Afraid to Ask),” and we did ask him about that simple savings rule.

Harold POLLACK: I got a bunch of emails that were essentially in the following form: “Dear Professor Pollack: I’m a 28-year-old single mom and I work as a cashier. You have just told me to save 20 percent of my money. F**k you.” And my responses to all of those emails was, “You know what? You’re totally right. I totally see where you’re coming from.” I think that my original card was really good for middle-class people like me. It wasn’t quite as good for people that were at different stages in their life.

Here’s another big topic where economists and popular-book authors disagree: what type of mortgage to get if you buy a house. The book authors prefer what are called fixed-rate mortgages: you are locked into an interest rate for the duration of the loan, which is often 30 years. Economists — unless interest rates happen to be very low — they prefer adjustable-rate mortgages, which means your interest rate can move up or down, depending on market conditions. I asked James Choi to explain why economists prefer the adjustable rate; in his paper, the explanation was fairly complicated.

CHOI: It is complicated. The reason that popular authors strongly recommend fixed-rate mortgages is that they sound very safe. You have a fixed monthly payment. What could be safer than that? Now, the hidden risk in fixed-rate mortgages lies with the inflation rate. So you take out the mortgage. Inflation comes in unexpectedly high over the life of your mortgage. That means that the real burden of your debt repayments is lower than was expected. But there’s the flip side, which is if inflation is surprisingly moderate over the course of your mortgage, then your real payment burden is higher than it otherwise would have been. And so there is a risk that is associated with fixed-rate mortgages, it just happens to get realized slowly over the life of the mortgage.  

And what about an adjustable-rate mortgage?

CHOI: Adjustable-rate mortgages, they feel quite risky because their monthly payment moves around over time. And so that’s why the popular authors are quite negative about the adjustable-rate mortgages. And if they do recommend the adjustable-rate mortgage, they typically have an upfront period where the interest rate is fixed for three years or five years or whatever. So they say make sure that this fixed-rate period is coinciding with the length of time that you’re going to stay in the house. Basically don’t expose yourself to the floating rate portion. But actually, adjustable-rate mortgages are relatively low-risk on another dimension, which is that their real payment burden over the long run is almost completely insensitive to the inflation rate. So the real payment burden of adjustable-rate mortgages in some sense is less volatile than for fixed rate mortgages. 

Now there’s another factor, which is that adjustable-rate mortgages tend to on average have lower interest rates than fixed-rate mortgages. So you kind of put all those factors together, and at least the two economic models that have really been out there in the literature suggest that for most people, the adjustable-rate mortgage is preferable unless the fixed-rate mortgage rate is kind of a historic low. Or if you’re really stretching your budget to buy your home, in that case, you probably should go with a fixed-rate mortgage. 

Okay, I think we’re starting to get a sense of why most people don’t go to economists for financial advice! I did ask Choi whether most economists he knows choose an adjustable-rate mortgage, as his research advises.

CHOI: I haven’t asked, but I’m going to guess that most of them have fixed-rate mortgages. 

DUBNER: Uh-oh. So wait a minute. You’re saying economic theory says that adjustable is plainly better. Why would economists themselves not follow that advice? 

CHOI: Many economists actually don’t put a lot of expert thought into their own personal finances. That’s one. And two, the academic literature on optimal mortgage choice I think is not very well known. When I started teaching this personal finance course a few years ago, many of my economist colleagues told me, “You know, I should take that course.” And a little hobby of mine is to just ask economist colleagues, “Hey, you made this financial decision, how did you make it?” And it’s usually some very ad-hoc process. Or they just went with the default option in the retirement savings plan. There is often not a high level of sophistication in the way these folks are managing their personal finances. And I think that it has to do partly with the professional incentives in our field where we are rewarded for writing down, say, highly abstract models and solving them. And so when it comes to their own personal finances, they end up falling back on rules of thumb and ad hoc procedures. 

So most economists, James Choi says, prioritize high-level research over low-hanging household-finance questions — which, let’s be honest, makes a lot of sense. That’s where their professional incentives are pointing them — and if that means not thinking much about their own finances, so be it. Still, it does make me wonder why we want to look to economists for financial advice at all. And there’s another issue. Even if economists are really smart, and good at math, do they really get what it means to think like a human? After the break: one popular-book author says he doesn’t think so.

HOUSEL: You cannot read a paper or look at a spreadsheet and change the amount of dopamine in your brain.

My name is Stephen Dubner, this is Freakonomics Radio, we’ll be right back.

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Before the break, the Yale finance professor James Choi was telling us that most people prefer to get their personal-finance advice not from economists like him but from the authors of popular books, like Morgan Housel.

HOUSEL: I am the author of the book The Psychology of Money, and I’m a partner at the Collaborative Fund. 

The Collaborative Fund is an investing firm, but Housel isn’t on the investment side. He’s essentially the house author, writing and speaking about finance. Before that, he wrote for The Motley Fool and The Wall Street Journal. He published The Psychology of Money in 2020 — too late, as it turns out, to be included in the top 50 personal-finance books that James Choi analyzed. Otherwise, it would have been included: Housel’s book has sold more than two million copies.

HOUSEL: We spent the last two years struggling to keep it in stock. We just can’t print enough. 

Housel grew up in California. He was a competitive ski racer.

HOUSEL: The quirk I would say is that I was a ski racer during my high school years. During the years in which other people would go to high school, I did not attend a high school. I did an independent study program that was sanctioned by the state of California. But I did virtually nothing to get the quote unquote diploma that they gave me when I was 16. 

When he was 17, two of his close skiing friends died in an avalanche.

HOUSEL: Yeah. I’d known them forever. We’d ski together six days a week for our entire adolescence and teen years. And I had been with them that morning. We were doing this out-of-bounds skiing, which is illegal. We would ski down this out-of-bounds run and then we would hitchhike back because when it’s out of bounds, there’s no chairlift. They went and did this run again. I decided to skip it and I was going to go pick them up in my car rather than them hitchhiking home. And that was when they were killed in the avalanche. Their bodies were found the next day. And then a few months after that, I broke my back skiing. So that was kind of the wake-up call of like, okay, it’s time to go figure out something else to do with my life now. 

He worked some odd jobs, did some community college and then some university.

HOUSEL: I eventually transferred into the University of Southern California, which is where I got my degree.

DUBNER: And you studied econ, is that right? 

HOUSEL: Yes. 

DUBNER: Looking back, do you feel that you learned anything particularly useful, interesting about personal finance by studying economics in college? 

HOUSEL: No, I really think the answer is no. I’ve thought really deeply about this, and it’s not to say that I didn’t learn anything useful. I mean, the most useful thing I got is I met my wife at U.S.C. — that was far and away worth the cost of admission ten times over. But in terms of what I learned, when you learn economics at the academic level — you are very familiar with this — it 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. 

I think this is a really important point that Housel is making here — that psychology, especially, plays a big role in our money decisions, for better or worse, and that economists typically haven’t had much interest in (or even awareness of) basic psychology. Many of their models assume the sort of rational, statistical decision-making that not many human beings actually practice. But: there has been a small revolution in this realm — behavioral economics, it’s called, which is a blend of econ and psychology. We’ve done many episodes on this show about behavioral economics — and James Choi calls himself a behavioral economist. So I asked Morgan Housel what he thought of Choi’s new paper — which attacks a lot of the advice given by writers like Housel.

HOUSEL: My general response to the paper was, it’s based off of this idea that economists can have the quote-unquote “right” answer to these problems, that they know the right thing to do with your money. And then they can therefore compare right versus what’s actually out there. And that is an idea that I fundamentally disagree with. There is not the equivalent of two plus two equals four in personal finance. You cannot read a paper or look at a spreadsheet and change the amount of dopamine and cortisol in your brain. You can’t do it. I think the best that we can do as individuals is look at our own personal financial past and realize that that is probably how we’re going to roughly behave in the future. If you are the kind of person who panicked out of your stocks in 2008 or March of 2020, you are probably going to do it the next time. A lot of the evidence shows that we will not learn from these mistakes because it’s easy to underestimate how quickly the emotions will come rushing back during the next surprise, during the next crisis. These are not things that have to do with a lack of intelligence or lack of information; it’s just how we’re wired. 

Let me disagree here with Morgan Housel and take the side of economists — or at least the side of science. Even if it’s true that we are “wired,” as Housel says, to have certain emotional responses to certain stimuli, the science suggests that much of our early wiring is obsolete in the modern world. But it may be that our emotional responses to money aren’t wired; it may be that we’ve been conditioned into certain responses, or maybe we’re just responding to incentives. And there are a lot of incentives to respond to. Think about the size of the financial services industry, and the whole consumer economy: there are thousands of firms doing everything they possibly can to get us to spend money in ways that may not be in our best interest. Who really thinks it’s a good idea to pay 15 percent interest on a credit card — other than the credit-card company? It’s also true that a lot of us fall into bad habits when it comes to money. And as we know, habits are sticky. But that doesn’t mean we have to just give up! Rather than curse the fact that we may be “wired” to behave a certain way, we try to break our bad habits. Yes, it can be hard — but also worthwhile. Think about smoking. Once the evidence was clear on the danger of smoking, we collectively put a lot of resources into curtailing this bad habit — and that effort has been fairly successful. So shouldn’t we at least try to change our bad financial habits? Maybe we do this from the demand side (that’s us, the consumers) or from the supply side (that’s the companies that are selling to us). Or maybe both! Let’s take a look at consumer debt. One of the biggest disagreements between the economists and the personal-finance authors is how to pay off credit cards and other consumer debt. Here’s how James Choi summarizes the debate.

CHOI: Economists would say that the no-brainer thing to do is to focus your payment on the highest interest rate debt that you have, because that’s what’s costing you the most to sustain. And about half of the popular authors say you should focus on the debt that has the highest interest rate. 

DUBNER: But then I’m seeing what you write about Dave Ramsey and this “debt snowball” method.

CHOI: Yeah. So the other half of the authors, and really it’s almost evenly split, say that you should do something like the debt snowball. The debt snowball method is basically take the debt that has the smallest balance and focus your energies on paying off that debt because when you zero out a debt account, that is going to give you a shot of motivation and that is going to help you finish your debt repayment journey. And so Dave Ramsey says, “I know that mathematically, this is not the optimal thing to do. This is going to cost you more money relative to if you concentrated on the highest interest rate debt.” But he says, you know, “This is all about behavior change. You need to have these quick wins in order to stay motivated. Otherwise, you’re just going to give up and that’s going to cost you more money down the road.”

Here’s Dave Ramsey himself, from The Ramsey Show. 

Dave RAMSEY: I understand the debt snowball’s not mathematically correct. And I don’t really care. What matters is what works. 

And where does Morgan Housel fall on the debt snowball question?

HOUSEL: On that argument, fully with Dave Ramsey. And 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. There’s probably some equivalent to doctors who say it’s fine to eat some Twinkies once in a while. It might be even fine to smoke once in a while, because it’s realistic, even if it’s not the right thing to do. I realize that you’re a human being and you are flawed like everybody else, and therefore this is just what works in reality. 

DUBNER: Not to split hairs here, but when you say the number of people that Dave Ramsey has helped, what’s the evidence for that? In other words, yes, there’s a lot of personal-finance advice. But what do you know, if anything, about the actual return on that advice? 

HOUSEL: No, that’s fair. I guess I’m taking a leap of faith that people could poke holes into, that a lot of book success and success in the content space is word of mouth. So it’s my assumption that Dave Ramsey sells a lot of books because people went to their cousin or their neighbor or their brother or their coworker and said, “This works for me. It might work for you, too.” The only way to sell a ton of personal finance books is through word of mouth, and people only do word of mouth when it has been successful for them personally. 

After I spoke with Housel, we did some research and found there is some evidence about Dave Ramsey’s impact. One of Ramsey’s consistent messages is simply to “spend less and save more.” The economist Felix Chopra examined what happened when Ramsey’s radio show came into a new market — and Chopra found that among Ramsey listeners in those markets, “exposure to the radio show decreases household expenditures by at least 5.4 percent.” So maybe we shouldn’t be too quick to judge Ramsey’s debt-snowball idea. Even the economist James Choi admits it may not be a terrible strategy.

CHOI: I’m actually open-minded about this. I think the best diet is the diet that you can stick with. And so the Mediterranean diet or the Atkins diet — there are a bunch of ways that you can get to a reasonable place. So if you’re the type of person for whom the debt snowball really is motivating, then go with the debt snowball. Unfortunately, I don’t feel like I’ve seen evidence that really convinces me at the moment about the efficacy of one debt repayment strategy versus the other. I did once try to convince a major debt-collection agency in Europe to test which of these strategies worked better. Unfortunately, I wasn’t able to convince them to pull the trigger at the end. So this is something I’m very interested in because I think this is a huge issue that faces a lot of people. And how is it that we as economists don’t know what is the most effective way for people to get out of debt? I think it’s just a huge gap in our knowledge. 

DUBNER: Economists really hate what you call mental accounting, which is dividing money into different baskets or setting up a vacation fund or whatnot. Most humans love mental accounting. Tell us why we’re wrong and you’re right. 

CHOI: 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.

DUBNER: I understand the logic of that, but I think it fails to understand the psychology of most people, in that there’s such a thing as peace of mind, and there’s such a thing as being able to sleep well at night, and there’s such a thing as being able to actually take the vacation that you told your kids you’d be able to take, because you know you’ve put a few thousand dollars aside in a separate account. So do you really not want any of us to do anything like that? You really think we’d all be better off if we didn’t do that? 

CHOI: I actually have some sympathy for mental accounting. It does provide that peace of mind that you are going to have enough money to go on that Hawaii vacation. It’s just easier to keep track of things and know whether you’re on target, first of all. Second, there is some evidence from economists that having mental accounts helps motivate us to keep on saving, because putting money into this little bucket in my overall nest egg just makes really salient that, “Hey, I have a Hawaii vacation that I’m planning. And this 20 bucks that I’m putting in this little mental account is making the Hawaii vacation come a little bit closer to reality.”

The concept of mental accounting was introduced by the economist Richard Thaler, who helped create the field of behavioral economics. Here is Thaler from a 2018 Freakonomics Radio episode called “People Aren’t Dumb. The World Is Hard.” This was not long after Thaler had won a Nobel Prize.

Richard THALER: You get this call at 4:00 a.m. Chicago time, and once they’ve convinced you this is not a prank, they say, “Okay, get ready. There’s a press conference in 45 minutes.” And the first question is, “What are you going to do with the money?” And all I could think of was, “Well, to an economist this is a silly question.”

DUBNER: To most economists, perhaps.

THALER: Certainly to a non-behavioral economist, it’s a silly question.

DUBNER: Because the answer would be, “It just goes into the pool with the other money. It’s no different than any other.” Is that why?

THALER: Right. I’ve thought that maybe the hedonically optimal way to spend the money would be to get a special credit card, the Nobel credit card. And then when I decide to buy a ridiculously expensive set of golf clubs, hoping that that will turn me into a competent golfer, then I just whip out the Nobel card. That might be a good idea.

So maybe mental accounting isn’t such a terrible idea. Here’s another point of contention between most economists and most personal-finance authors: should investors go out of their way to buy stocks that pay dividends? James Choi again:

CHOI: There’s been this decades-long mystery the financial economists have tried to understand about why companies pay dividends at all and why people seem to like dividends. I remember getting my first dividend deposit from the small amount of money I had in a brokerage account at the time. And I remember feeling quite good about the fact that I had gotten this dividend payment. What I didn’t understand at the time, and actually I don’t think I really understood it until I had to teach a corporate finance course as a professor — if you have a stock, let’s say that the stock is trading at $10 per share and the stock pays a $1 per-share dividend. As soon as that $1 per-share dividend is paid out, the stock’s price drops by a full dollar. So now it’s a $9 per share stock instead of a $10 per share stock. And I don’t think that that’s well-understood. People think that that dividend payment comes almost for free, so I felt like I was making some financial progress when that dividend deposit was made. But no, it just made a transfer from one account to another. 

The author Morgan Housel, meanwhile, does see the appeal of dividend stocks.

HOUSEL: It gives a tangible view to investors that things are moving at the company. I actually got some cash paid back, even if there is a more efficient way to return capital to shareholders. I think from a psychological perspective, it just gives investors a tangible view of success at the company that’s hard to describe any other way.

Where the authors and the economists agree is that investing in the stock markets is a good idea — even though many, many U.S. households don’t own stocks. James Choi again:

CHOI: This so-called stock market nonparticipation puzzle has had a lot of economists spill a lot of ink with theories for why. The leading theory is that there’s some kind of fixed cost of investing in the stock market. And so what this theory helps explain is why is it that richer people are more likely to invest in the stock market than poorer people. Now we are pretty sure that that theory is not a completely satisfying theory because even Americans in the top 5 percent of the wealth distribution are not universally invested in stocks. So there has to be something else that’s going on. And I think that the most likely force that is keeping a lot of Americans out of the stock market is that people are just too pessimistic about the returns they’re going to get on the stock market. So if you look at these surveys of Americans, you ask them, what is the chance that the S&P 500 or some other U.S. stock market index will go up over the next year? The answers they give are considerably lower than the historical experience of the stock market. 

The economists and the popular-book authors also agree that the most sensible way to invest is to buy something like low-cost index funds rather than trying to beat the market with individual stocks or paying a big fee for a fund that’s actively managed.

CHOI: The evidence, I think, is pretty strong that on average, passive funds beat active funds. That’s because there are just a ton of costs associated with trying to beat the market: trading costs, tax burden, and so on. And so both the popular authors and the economists are pretty strong in saying that passive management is the way to go. Now, why is it that there’s so much agreement? I think it’s because there is a lot of publicization of the statistics comparing passive index funds to actively managed funds and showing that most of the time the index funds are beating the active funds. We probably also have Jack Bogle of Vanguard to thank here.

Jack Bogle was a pioneer of the index fund, the first person to make them available to individual investors. He died in 2019 at age 89. We had him on the show a couple years before that, in an episode called “The Stupidest Thing You Can Do With Your Money.” He talked to us about starting Vanguard, and how the smart money kept telling him how stupid he was.

BOGLE: The more dissent I got, the more confident I was that I was right. I’m that kind of a contrarian person. So people laughed. There was this great poster that said “Stamp Out Index Funds.” There’s Uncle Sam with a cancellation stamp all over the poster, and “Index funds are un-American.”

DUBNER: And they were considered “un-American”— that argument was what? 

BOGLE: The argument is, “In America, we don’t settle for average. We’re all above average.” But, of course, we’re not all above average. The poster was put out by a brokerage firm. The thing about the index fund — no sales loads, no portfolio turnover. You don’t buy and sell every day like these active managers do. It’s Wall Street’s nightmare and it still is!

But as Morgan Housel points out, not even the godfather of the index fund was fully rational with his own investments. Jack Bogle’s son became an active-fund manager — trying to pick winners rather than just tracking the market.

HOUSEL: And Jack Bogle, he invested in his son’s fund, and when asked about that, he said something along the lines of, “Life is contradictory. That’s just how life works sometimes.” And I loved just that reality and that admission that even if this is what Jack Bogle believed in his heart, of how you should invest in low-cost indexing, he’s going to invest in his own son, even if it seemed antithetical to what he was doing himself. That to me is a perfect example of a real-world financial decision that sometimes doesn’t make a lot of sense, and it’s just messier than you want to believe, but that’s how people actually make decisions in the real world. 

After the break: what’s the biggest money mistake you’ve ever made? 

Tate GARDNER: They’re extremely impractical and I’m just going to run out of money, and they’ll just be collecting dust in my room. 

And if you’d like to hear some of the earlier episodes we’ve been name-checking on today’s show, you can find our entire archive on any podcast app, or at freakonomics.com. We’ll be right back.

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We asked you, our listeners, to share some of the biggest money mistakes you’ve made. Here’s what you said:

McDOUGAL: I took out way too much in student debt and am going to be figuring that out for the rest of my working life, I think.

Spencer LEVINSON: I used to spend toward the upper end of my credit limit and pay it off immediately, thinking that that would actually boost my credit score. And I later learned that it actually does the opposite. 

KULMAN: I couldn’t figure out what was wrong until I finally discovered — I remembered, “Oh, my God, I owe $2 to this credit card, that’s like destroying my credit.”

Marc POIRIER: I lost 30 grand when I started investing when I was 20 and I was working in the oilfield. 

Angelika: I do keep the majority of my money still in savings accounts today. That’s just like a genetic thing I think.   

Daryn LEVESQUE: I wish I had understood earlier on how easy it is to obtain personal debt instruments, yet how hard it can be to get out from underneath them. 

Tate GARDNER: Hello. My name is Tate. I’m 12 years old and I live in a suburb of Minneapolis, Minnesota. A money mistake I made was buying a lot of Pokémon cards. They’re extremely impractical and I’m just going to run out of money if I only buy Pokémon cards and they’ll just be collecting dust in my room. So there’s no point buying them anyway.

I asked James Choi, the economist, what he considers the most common money mistakes made by the average person.

CHOI: I’d say two things that are somewhat related. One is just not having a rainy-day savings buffer. So life is just very, very difficult if you have no buffer for these predictable emergencies. You get a flat tire, you have to patch a hole in your roof, whatever it is. Just to have a couple months of income at least salted away is a pretty high priority. So a lot of Americans don’t have that.

DUBNER: I mean, a lot of people would say, “What are you talking about?” You’re an economist at Yale, which is a great job. Your wife is a physician. You guys are in really good shape financially. A lot of people can’t even start to think about having a rainy day fund because — look, we know what wage stagnation has looked like over the past 20, 30 years. So a great many people are just not able to even get on solid ground, much less get the rainy day fund.

CHOI: Look, everybody wants to have more income than they do. But if we just look at Americans in the 1950s — we had much lower income in the 1950s than we do now, and personal savings rates were a lot higher. Or you can look at China, where their per-capita G.D.P. is a fraction of what ours is. And yet you see personal savings rates in 30, 40, 50 percent ranges. And so it really is about what standard of living do we find tolerable? We know that there’s only so many dollars that’s going to come into your life. And so the question is, do you deprive yourself now or do you deprive yourself later? Maybe it’s better to have a moderate level of deprivation, both today and tomorrow, rather than having very little deprivation today and then a lot of deprivation tomorrow. 

DUBNER: Why do people save so little? Is it simply because there are so many fun things to spend money on today, much more than there was in the ’50s? 

CHOI: I think that’s one of the great mysteries of our economy. Now, the optimistic way to look at the lower savings rate is to say that our social safety net is much more developed now than it was in the ’50s. Our financial system is more developed now. And so you can get loans in a tough spot. You get better insurance than you did before. And so there’s less of a need to engage in precautionary savings now than you did in the ’50s. And so that’s why we save less and that’s why we save less than the Chinese, because the Chinese don’t have nearly as developed an economic system and a social safety net. So they have to save more. So that’s one perspective on it. Another perspective is, hey, we just made it a lot easier to tap your home equity. We made credit cards a lot more available. Companies have gotten a lot better at marketing their goods than they used to be. And so maybe it really is about greater temptation in the economy now than there used to be. I don’t really know the answer to this. 

DUBNER: And then you were about to give me kind of big common mistake No. 2. 

CHOI: Common mistake No. 2 is just having too large of a fraction of your monthly income tied up in what economists would call a consumption commitment. This is like a rent payment or a mortgage payment or private-school tuition where basically there’s no give in that spending category over the short term. Now, what does that do? It means that if you have any sort of negative economic shock in the short term, it becomes very difficult for you to make a budgetary adjustment. And that’s how a lot of people get into trouble. So a lot of these authors will say you should not have more than 50 to 60 percent of your income committed to inflexible spending. 

DUBNER: And your number then would be what? 

CHOI: I think that that’s probably pretty sensible. What you see in the data is that there are a bunch of Americans that live paycheck to paycheck. And that they also have significant illiquid assets. So this is kind of the paradox of you live in this beautiful home, you have a six-figure income, and yet you’re out of money at the end of the month. This is a phenomenon that economists call wealthy hand-to-mouth. These are people basically who are house-rich, cash-poor. And I think it’s a pretty stressful way to live. 

This made me curious to know how Morgan Housel, the author of The Psychology of Money, thinks about his housing costs.

HOUSEL: My wife and I paid off our mortgage when we had a 3 percent, 30-year, fixed-rate mortgage. It is the worst financial decision we have ever made, but the best money decision we have ever made. 

When Housel says it’s “the worst financial decision” — that might need a little explaining. A mortgage with 3 percent interest is considered very attractive. When a bank lends you money that cheaply, not only do you get to live in the house while you pay it off but whatever leftover money you have can be invested in the stock market, which historically pays out well above 3 percent. So you get to use money from the bank — which it got from the U.S. government even cheaper —and you can grow your money, plus you get a tax break on your mortgage payment, since the government likes to subsidize home- ownership. That’s why most people consider a low-interest mortgage to be a great thing, and certainly worth keeping if you have one. But not Housel.

HOUSEL: On paper, on a spreadsheet, it’s the worst thing we could have possibly done because it’s basically free money that we gave up. In the real world, in our household, though, there is nothing we have ever done with our money that gave us more joy, more sense of freedom and independence and stability for our children than doing that thing. I have so many friends who, even when I frame it exactly like that, they say, “I still don’t understand why you do it. And I would never do it.” And I’m saying, “That’s great. I know it doesn’t work for you, but it works for me.”

DUBNER: So what’s the emotional upside for you for having made that decision that most economists and even many financial advisers would advise against? 

HOUSEL: Rather than trying to maximize the R.O.I. on our capital, the return on investment, we are trying to maximize how well we sleep at night. Other people I know would disagree with that. They have a different personality, a different risk tolerance. But for us, it was not about making the spreadsheet happy or making sure all the numbers lined up perfectly. It was, how can we use money as a tool to make ourselves happier, and give us a sense of independence, which is always what I’ve wanted to chase. Rather than just trying to maximize return and generate the highest net worth, all I really wanted out of money was a sense of independence and controlling my own time. And paying off a mortgage did that. 

DUBNER: What was it about having the mortgage that led you to not sleep well at night? 

HOUSEL: I think it was probably a simple idea that every dollar of debt you own is a period of your future that somebody else has control over. I think what you’re trying to get — you can correct me if I’m wrong — is trying to explain what we did in rational ways when I fully admit it was not a rational thing to do. It just made us feel good, even though I can’t explain it on a spreadsheet.

DUBNER: Right. Because on the rational side, the economist would say, “Well, Morgan, what about opportunity cost? Let’s say you owed the bank $1,000,000, and rather than spread the remainder of that mortgage out over 30 years, you’re saying, ‘No, no, no, I’m going to take $1,000,000 from our investment account or a checking account, send it to the bank, pay off the note, and now I own the house.’ But now you don’t have the million dollars.” I understand why that’s a reasonable versus a rational choice. What I don’t understand is how in your mind that creates more opportunity when you’re giving up the money that you had.

HOUSEL: So many of the most important things in finance, and this is true for a lot of areas in life, are things that you cannot measure. We paid off our mortgage five years ago. Every single month, on the first of the month, I have this little grin on my face of like, “This is mine. I don’t owe anyone for this thing. This is my house.”  We now have two kids and I think as a provider, having that extra sense of stability for my family, that no one can take this house away from us, this is our house. Having that sense of stability gave me a sense of happiness and fulfillment that is very hard to put into numbers or even put into words, I would say. 

The economist James Choi doesn’t have a mortgage either. But that’s because he doesn’t own his home. 

CHOI: I’m a renter for life, so I do not have a mortgage. There is this popular notion that renting is throwing your money away. And that just can’t be true in a well-functioning market. So to just geek out a little bit: what exactly are you doing when you buy a house? You’re just prepaying all of the rent that the house would have commanded over its entire working life. Are you going to pay this in monthly increments or are you going to pay it all upfront? It’s a little bit more complicated than that, but that’s the basic intuition. And so in a well-functioning market, the marginal person should be indifferent between buying and renting. 

DUBNER: To me one of the biggest differences is when you own someplace, you feel totally different about the place and you treat it differently, you invest in it differently, you decorate it differently, you have a different relationship with your neighbors and your community and so on. That’s purely a psychological benefit. But can’t you put that in the plus column for owning versus renting? 

CHOI: Well, absolutely. I mean, it goes both ways. So on the one hand, nobody ever changed the oil on a rental car. So you for sure are not going to take care of a rental property as well as you would for a home that you own on your own. So in that sense, there’s more wear and tear on rental properties. And so that’s going to raise rents relative to if the thing was owned. On the other hand, there is this psychological pleasure that people get from this notion that, “Hey, I own this place that I am living in.” And so if there is a real psychological pleasure, it means that people are going to pay more to be able to own. Well, if you’re paying more for the property, that’s going to decrease the financial returns to owning the property down the road. So I think it’s not really clear whether financially it’s better to rent or own. 

DUBNER: So you’re never going to own a house, it sounds like. 

CHOI: Well, I get zero psychological satisfaction out of the thought that I’m owning the place that I live in. So I’m kind of a weirdo in that way, and my wife’s the same way.

This may be the biggest difference between the popular-finance authors and the economists. Many economists, as James Choi admits, are kind of weirdos. Personally, I love weirdos — all kinds of weirdos — and that includes economists, for sure. But it may be that for something as important and intimate and confusing as money — your money and your family’s money — yeah, maybe economists aren’t the first place you should turn. I found that the concluding paragraph of James Choi’s new paper summarizes economist weirdness quite well. I asked Morgan Housel if I could read it to him, and hear his response.

DUBNER: Okay, he writes in the conclusion, “Popular financial advice can deviate from normative economic theory because of fallacies.” Response there?

HOUSEL: I’d say because of “realities,” is the word I would change there. 

DUBNER: “But,” he writes, “popular financial advice has two strengths relative to economic theory.” Do you have any comment on the amazing fact that the popular advice may actually have two strengths? 

HOUSEL: It has strengths because it’s realistic and people will actually pay for it and actually read it versus academic papers that nobody reads. 

DUBNER: First strength, he writes, “The recommended action” — meaning in the popular-finance books — “is often easily computable by ordinary individuals; there is no need to solve a complex dynamic programing problem.”

HOUSEL: People are not calculators, they’re storytellers. They need a couple of lines that make sense to them. That’s how people think about politics, it’s how they think about relationships, it’s how they think about money. 

DUBNER: “Second,” he writes, “the advice takes into account difficulties individuals have in executing a financial plan due to, say, limited motivation or emotional reactions to circumstances … Therefore, popular advice may be more practically useful to the ordinary individual.”

HOUSEL: That might be the best sentence in the entire paper.

DUBNER: There is one more sentence. I’ll just run it by you. “Developing normative economic models with these features” — meaning the features of the popular advice — “rather than ceding this territory to non-economists, may be a fruitful direction for future research.” What do you think he’s really saying there? 

HOUSEL: I think he’s saying if academic economists took the approach of understanding how people actually make financial decisions and what they actually do, versus what they should do, they would get much closer to reality. 

DUBNER: I was thinking he was also saying, “Oh, man, we could write books that sell a couple million copies too, if we could develop, quote, ‘normative economic models’ with these features.” Do you feel insulted by the argument he’s making in this paper? 

HOUSEL: I’m not insulted, but I’m not surprised. I’m not surprised that people who are very highly credentialed, are very intelligent, and have spent their lives devoted to one sphere of finance view that sphere as superior to other people who are less credentialed, less educated, and are promoting advice that they view as wrong. I’m not surprised by it. I just don’t think it’s practical in the real world. 

On this point — the intelligence of economists — I wanted to go back one last time to James Choi.

DUBNER: How smart do you have to be in the modern world to be good at personal finance? 

CHOI: Smarter than me. 

DUBNER: Okay. So that’s scary. You’re a Ph.D. economist. And wouldn’t the better answer be, “No, no, no, no. You don’t have to be smart. The system is set up so that anybody can manage their personal finances well”? Wouldn’t that be the better answer rather than you have to be really, really smart to figure out all this complication and this massive set of options and possible wrong decisions? 

CHOI: Well, I think that it’s actually not that hard to get to someplace reasonable. What’s really hard is to get to the optimal solution. I mean, life is complicated. And there are so many factors that our economic models don’t really take into account because they are too complicated, they are too person-specific. They are these Byzantine rules that we’ve created as a society — in tax code, and all these institutions that are interacting with each other. So to really get the optimal solution, I think it’s almost hopeless. But to get somewhere reasonable where you have a comfortable life and you’re not worried about money all the time and stressed out, I think that’s pretty doable even for the ordinary person. 

What do you think? Is it pretty doable for the ordinary person? Is it pretty doable for you? I hope so. I also hope this episode may have helped you think about how you think about money. Thanks much to James Choi, Morgan Housel, and everyone who sent us voice memos about their money stuff. Especially Tate, who sounds like he’s kicked the habit of spending all his money on Pokémon cards.

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Freakonomics Radio is produced by Stitcher and Renbud Radio. This episode was produced by Alina Kulman. Our staff also includes Neal Carruth, Gabriel Roth, Greg Rippin, Zack Lapinski, Rebecca Lee Douglas, Morgan Levey, Julie Kanfer, Ryan Kelley, Katherine Moncure, Jasmin Klinger, Eleanor Osborne, Jeremy Johnston, Daria Klenert, Emma Tyrrell, and Lyric Bowditch. Our theme song is “Mr. Fortune,” by the Hitchhikers; the rest of the music this week was composed by Luis Guerra. You can follow Freakonomics Radio on Apple Podcasts, Spotify, Stitcher, or wherever you get your podcasts.