Personal Finance VS Traditional Economic Theory
In the field of finance, two vital areas that dictate the course and phase of action of many private and public institutions are traditional economic theory and behavioral economics/finance (where personal finance falls under). In this regard, James J. Choi, a notable finance professor at Yale University, examined the top 50 most famous personal finance books in 2019 to compare and contrast the two disciplines.
Yes, these personal finance books include best-selling pieces such as Robert Kiyosaki's Rich Dad Poor Dad, Ramit Sethi's I Will Teach You to Be Rich, Jesse Mecham's You Need a Budget, and of course, numerous book publications by Dave Ramsay's. Choi then likened the overarching tenets of these books to the principles of traditional economic theories.
The US National Bureau of Economic Research then published the by-products of his findings. In summary, the five comparisons he made are the following:
Economic Theory vs. Personal Finance
Making Sense of The Difference
The primary distinction lies in the discipline each one pursues. The traditional economic theory concentrates on objectiveness — a segment that strives to learn the most appropriate course of action for each financial and economic challenge using observable universal truths and logical measures. A highly regarded example is the "supply and demand model."
Above, we can see that the market theory endorses prioritizing the highest-interest debts first, regardless of the obligation size. This is undoubtedly a sound mathematical decision as it would yield you paying off your obligations in the most cost-efficient manner. However, this action step assumes you will be objective all throughout the repayment duration and not once waver.
For that reason, it does not account for our human tendencies, which personal finance takes into significant consideration as most individuals are more likely to get momentum and keep paying off their debts when they take the most manageable course of action — paying off their least debt first. Why? Well, this is primarily because human behavior (especially our emotions) and psychology are the crucial focus of behavioral economics/finance and, by extension, personal finance.
Understanding this provides substantial financial insights about our society. In addition, examples comprise purchasing patterns and tendencies/biases that consumer companies consider—appealing to dopamine receptors of social media users for Advertising Giants such as Meta and Twitter to foster their advertisement revenue by employing tactics that keep you scrolling and hooked.
A Similar Perspective
Interestingly, one category is identical among the five categories — the mutual fund section. Why? This is because, time and time again, history has demonstrated that the straightforward index-following fund outperforms more than 90% of all mutual funds/ETFs.
Moreover, since a fund manager is not actively managing the fund, across-the-board fees are cheaper as management fees are out of the equation. Thus, instead of pushing to "beat the market returns," it is easier as well as cost-efficient to pick an index fund while arguably providing historically best-in-class consistent returns.
The Bottom-line
In a way, behavioral finance/economics and economic theory are like comparing Social Science and Mathematics. Unsurprisingly, issues that both domains could solve can deliver different solutions. One aims to solve it in the most objective and rational way, while the other one takes into account that humans are creatures of emotions and, thus, we are often not logical.
The truth is that both are crucial and valuable to our overall economic system. But, more importantly, it is frequently difficult or nearly impossible to adapt landmark economic theories because of our irrational nature. We are not robots with no emotions and no innate biases. Therefore, learning why and how we do things is of utmost importance.
The Bright Future Ahead of Us
Nevertheless, throughout history, we have demonstrated to be species that improve, learn, and adapt from our mistakes. Hence, we may one day line up our response just like in the "mutual funds" category. In fact, we are now seeing this with the introduction of sophisticated data visualization tools like ETF Insider, where you can precisely pinpoint fund overlaps and overexposure and identify specific key information about managed funds which ultimately helps us to pursue the "objectively best course of action" that economic theories propose while simultaneously preserving our humanity.
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