A recent article in the Journal of Economic Perspectives by James Choi, a finance professor at Yale University, looked at personal finance advice by economists and compared it to the advice given by non-economists in the popular press.
The article found differences between the advice given by the two groups that often reflect alternative assumptions about personal financial goals. There are also many similarities in the advice given by the two groups.
Both economists and non-economists recommend investing in passively managed or indexed mutual funds, because index funds tend to outperform actively managed mutual funds. Actively managed funds, which routinely buy and sell assets, charge investors higher management fees than buy-and-hold index-based portfolios. Few financial advisers can “beat the market,” at least not by an amount necessary to make up for their higher management fees.
Both economists and non-economists recommend that people invest so that the equity share of individual portfolios is “hump-shaped” with respect to age.
In the long run, the return on equities—common stocks—is much higher than on debt instruments or bonds. But short-term variability in common stock prices is much higher than in bonds. Since equities have higher returns and variability, people in their early and mid-careers should invest more in equities, but then in their late career and retirement invest less in equities to have more certain retirement incomes.
The major differences between economists and non-economists are their assumptions about the goals of individual investors. Economists assume investors start with no wealth, want to die with minimal wealth, and want to smooth their consumption over their lifetimes. Economists also tend to assume people are rational and want to optimize their portfolios.
Non-economists tend to assume people want to accumulate wealth for use in retirement and to pass on wealth to future generations. Non-economists also tend to assume people are emotional and need simple rules to follow.
Because most people’s incomes are low when they are young and old and higher in middle age, economists recommend low saving rates when people are young, higher savings in midlife, and then annuitizing income or negative savings in retirement.
Non-economists typically recommend saving 10% to 15% of income while working for retirement. Then they don’t recommend annuitizing their income, and many recommend keeping people’s real level of wealth constant or spending 3% to 5% of assets during retirement.
Considering and balancing the perspective of economists and non-economists is likely the best course for the individual investor.•
Bohanon and Horowitz are professors of economics at Ball State University. Send comments to firstname.lastname@example.org.