James Choi is Professor of Finance at the Yale School of Management. His primary research is in household finance and behavioral finance; his work on automatic enrollment has led to changes in pension plan design around the world. He has also published research on the effects of social identity and how to use psychology to increase preventive health behaviors.

Professor Choi is a two-time recipient of the TIAA Paul A. Samuelson Award for outstanding scholarly writing on lifelong financial security. He is a Co-Director of the Retirement and Disability Research Center at the National Bureau of Economic Research, an Associate Editor at the Journal of Finance, a member of the American Finance Association’s Ethics Committee, and a TIAA Institute Fellow. He has served on the FINRA Investor Issues Committee. He holds a Ph.D. in economics and an A.B. in applied mathematics from Harvard University.

Today we welcome James Choi, Professor of Finance at the Yale School of Management, to the show to share some of his insight into what he has dubbed practical finance. James has focused his research on behavioural finance, behavioural economics, household finance, capital markets, health economics, and sociology, and is turning this expertise into pragmatic knowledge marketed towards ordinary people. This reframing and reconfiguration of the theory for all people and the decisions they make, could not be more in line with what we are trying to do here at Rational Reminder, and this conversation with James was packed with so many surprising and informative responses to relatable questions. We ask James about index funds, the benefits of advisors, optimal equity, diversification, and much more. We also spend a little bit of time exploring the individual reasons that people have for their decisions, with James expanding on the disconnect between people's philosophy and their actions. Further topics include the role and impact of education, renting versus buying, and the formulation of his concept of practical finance, so make sure to join us and catch it all.

Key Points From This Episode:

• The failure of economic theory to explain everyday financial decisions. (0:03:03)

• A little about James' course on personal finance at Yale. (0:06:29)

• Economic theory and popular personal finance advice on optimal savings and consumption. (0:12:06)

• Looking at economic theory and popular personal finance's suggestions about optimal equity allocations for households. (0:19:33)

• The kinds of personal aversions people have towards their finances. (0:27:07)

• The impact that James' survey research has had on his perspectives on equity. (0:29:42)

• Practical application of economic theory to household decisions. (0:32:29)

• Increased awareness of the benefits of index funds. (0:42:59)

• James shares a few famous economists' investment strategies. (0:44:11)

• Some thoughts on approaches to and avoidance of diversification. (0:45:48)

• Differentiating between mistakes and unique behaviours we cannot justify. (0:52:26)

• The efficacy of education, financial advice, and personal experience in improving investment decisions. (0:55:44)

• Liquid and illiquid assets and renting versus buying property. (1:02:26)

• James talks about his excitement around his current work in practical finance. (1:07:50)

• How James defines success at this point in his life. (1:09:52)

Read The Transcript:

Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We are hosted by me, Benjamin Felix and Cameron Passmore, portfolio managers at PWL Capital.

Cameron Passmore: Welcome to episode 260. Ben, I said to you after we finished recording this conversation, I think we need a new index for rating conversations that we have. I don't think we've had as many wows as we had in this conversation with Professor James Choi, who is a Professor of Finance at the Yale School of Management. This conversation was fantastic. It was about practical finance, ordinary people. A lot of the questions are like, “Man, that's a really good question. Man, that's a really good question.” His answers were great.

His research spans such interesting things, like behavioural finance, behavioural economics, household finance, capital markets, health economics, sociology. He's got this practical application of his research that just applies to all of us. So many answers were just so good.

Ben Felix: You glossed over the term practical finance, which is a thing that James is trying to make into a thing, like how household finance became a thing not that long ago. We talked to John Campbell, who was closely involved with that, the growth of that idea. James talked about how he's trying to launch, I guess, practical finance, which is like, how do we take economics and make it useful for people who are making decisions and maybe just have access to a calculator, or a spreadsheet, or something like that? That's the general direction that we took. It's like, what does the economic theory say? What do people actually do? What do people say about why they do stuff and then how do we take all that and make economic theory useful to people making real decisions?

Cameron Passmore: Including economists that he would survey.

Ben Felix: Yeah, yeah. Sounds like, those were more casual conversations. But yeah, it sounds like, even the economists don't behave in the way that an economist would say you should behave. Yeah, Professor Choi’s work on automatic enrolments in pension plans has led to changes in plan design around the world. He’s done a lot of really practical work on household finance and behavioural finance.

He has also published research on the effects of social identity and how to use psychology to increase preventative health behaviours. He's got his PhD in economics from Harvard University. He's won tons of awards and holds lots of positions with different institutions. He's done fantastic research. He's also done fantastic review research on behavioural finance as a field of study. I think we were able to draw on all of that to get some really practical insights on good decision-making.

Cameron Passmore: Agree. With that, let's go to our conversation with Professor of Finance from Yale, James Choi.

***

Professor James Choi, welcome to the Rational Reminder Podcast.

Glad to be here.

James, in general, why do you think economic theory often fails to describe how real people make personal finance decisions?

That's a big question. I think that every theory, every set of theories is wrong. The statistician George Fox famously said that every theory is wrong, but some are useful. Anything that's going to have some explanatory power that has some ability to offer – insight is going to simplify the world, and so it's going to necessarily not get everything right. The question is, how wrong, or what kinds of wrong are you willing to tolerate because you'd think that the insight that's provided is reasonable for that cost.

Economic theory, just like every other theory has its blind spots, its oversimplifications, and its particular kinds of oversimplifications that had traditionally been made over many decades in economics, that at some point we decided that the wrongness was too much to be tolerated. This notion that everybody is perfectly rational and is able to do these complex calculations on the fly or not necessarily on the fly, but at least eventually get there. That was a pretty useful paradigm to maintain the research for a very long time.

Then you had people like Danny Kahneman, Amos Tversky, Richard Thaler having a lot of fun and showing ways in which we systematically make mistakes that seem to deviate from that rational paradigm. That birthed the field of behavioural economics, behavioural finance. I think the people are not rational, calculating supercomputers. They have limited amount of cognitive ability. Then there is cognitive illusion that we all suffer from to a certain extent. Then there's failures of self-control and motivation. All these things were swept under the rug and ignored really for many decades. We're still in the process of figuring out what is the right balance of these other forces to allow into our theories and into our models, again, recognizing that we need to oversimplify and get some things wrong in order to get greater insight into what might actually be going on in people's heads and complex economic systems.

Why do you think that that process of changing the paradigm, I guess, has been sloped? Because we've known this stuff for a while, but it's relatively recent, I think, that this is becoming a big thing in the literature.

This is nothing new. Thomas Kuhn, the famous philosopher of science, noted that paradigm shifts often take a very, very long time. I can't remember who it was who famously said that science progresses funeral by funeral. Once you have attacked yourself to a particular paradigm, it can be very hard for people who have built very distinguished careers, advancing a certain way of thinking and modelling the world, for them to give that up.

I think the field has made a big change, and this has become much more mainstream, but it just takes a long time, because nothing is convincing in and of itself. There's no evidence that can really be definitive for somebody who's decided that the world acts in a particular way, and I think you see that in our politics, most obviously, but that happens in science, too. This notion that even scientists are these perfectly rational beings that don't bring in their ideological prior beliefs about how the world works. That's just not true. We're all human, and we're all trying to grope our way to the truth.

Wow. That's fascinating. How did you decide to start teaching a personal finance course at Yale?

Early on in my career, I did some research on automatic enrolment in time and savings plans. It turns out that if you have to opt out of saving in your retirement savings plan, then you're much more likely to be contributing in the plan if you have to opt in. This is the automatic enrolment revolution, where the evidence was quite overwhelming that this makes a big difference in whether people are in or out of the plan. Even though at the time, this was thought to be a big deal, because economists said, for anything that's so large stakes as retirement savings, there's no way that something so minor as opt in versus opt out could possibly have any significant effect on what people end up doing. That was my start in the field.

When people would ask me, “What kind of research do you do?” If they were an economist, I'd say, I do behavioural finance, I do behavioural economics, I do household finance. For a non-economist, I wouldn't assume that they would know those terms. My go-to catchphrase was, I study dumb things that ordinary people do with their money. I think that's pretty well understood. That's what I was just saying for maybe 15, 20 years. At some point, I thought, maybe I should do something about the dumb part, instead of just, I shouldn't say exploit, but leveraging the dumb part.

Automatic enrolment, it takes advantage of the fact that people are amazingly passive in portions of their financial life. You leverage that, hopefully, for good to move people in a direction that is hopefully, in their best interest. You don't try to fight the inertia. You just use it. I think that that's not enough to really redo your entire financial life. I thought, maybe I should try to contribute to help people become smarter about their finances.

This is a fun course to teach, because I do try to bring in the science we have about how you should be managing your personal finances. This is not a basic financial literacy course. This is really a course that tries to bring you close to the scientific frontier. Somewhat different from what I've done before, because here, it really is about what you should do, rather than saying, “Ha, ha, ha. You're stupid. Let me show you exactly how you're stupid.”

That's a very funny way to explain it. How long have you been teaching the course?

I think the first time I taught it was five years ago. For a while, I was only teaching it every other year. Now starting with this year, I'm teaching it on a every year cadence.

Going through teaching students, what topics do you think are most impactful to them?

It's hard to know what's most impactful for them. The Protestant reformer, Martin Luther, said that there are three religious conversions that have to happen; the conversion of the heart, the conversion of the mind, and then finally, the conversion of the purse. That last portion is the hardest. The students do the problem sets. They do the readings, hopefully. Then what exactly translates into the financial lives, I actually don't know.

I think there is a lot that is counterintuitive about what economic science has included is the right thing to do. Life is complicated. Human nature is complicated. At the end of the day, who knows exactly what the students come away convinced by? I'll have to follow up with some of them five, 10 years later and see, what exactly did change for you?

What have you learned from teaching this course about how normal people, or I guess, normal Yale students, how they make personal financial decisions?

I think that there's a lot of incoherence and even just difficulty with calculations that are not that complicated, but which are maybe not exactly the first thing that you might think of. The greatest insight I have into what my students are doing in their personal financial lives is this portion of the course where I allow students to anonymously submit their own personal portfolio allocations. I say, submit your ticker symbols, submit exactly how much money you have invested in each security and the things that they do are crazy and incoherent. Mixing and matching styles, investing on opposite corners of the style box, or doing things like, they have a target date retirement fund, which is intended to be 100% of your portfolio.

Instead, they have 15% invested in this one target date fund, another 5% invested in this other target date fund that happens to have a fairly different target retirement date. It's like, this was not in accordance with the manufacturer's original instructions on how you should use this thing. But we know from large scale data that a lot of people do this with their TDRFs.

The technocrat has this great plan here. She designs a product in a certain way that goes to the real world and all sorts of weird things happen with the way people interpret and the way they use these financial products. You do see a lot of incoherence. At the point that these MBA students reach me, they've done the first year MBA core, so they've had their basic investment management core course. Then you see, a lot of them are totally undiversified in their portfolios. They're speculating in individual stocks and it's like, okay, well, you learn this, but clearly, you weren't convinced, because you aren't following what we taught in the core course in your own personal portfolio. That's why I want to have the appropriate amount of modesty as to what exactly in my course is the most impactful for the students, I don't know.

Those comments are super interesting, because we'll talk about some of your research on this later about how education maybe doesn't solve a lot of these problems. With what we just talked about as a background, I want to jump into some economic theory and how actual people behave relative to that theory. Can you talk about what economic theory suggests about optimal savings and consumption over the lifecycle?

Economic theory has, I’d say, three things. There are the primary drivers of how much you should be saving in any point in your life. Actually, economic theory has a theory of optimal consumption. It doesn't actually have a theory of optimal savings, so economic theory says, this is how much you should be spending at any point in your life and we're trying to balance a few motives. One is what we call the consumption smoothing motive, which says that the fifth slice of pizza is never satisfied with the fourth slice of pizza, which is never satisfying the third slice of pizza.

Instead of starving yourself one day and having an entire pizza for each meal on the next day, maybe you should just have a moderate amount of pizza on all days. It's consistent over time. This principle of diminishing marginal utility is the technical term, just at some point, the pleasure from extra spending just isn't that great, but that first dollar spending is really valuable, so you should have a consistent level of spending over time. That's one consideration.

The other consideration being that there is usually a positive return from investing. Delaying gratification is something that's rewarded, and so maybe you don't want to have exactly the same amount of consumption every period, but maybe you want your consumption to be growing over time, because you want to invest some of your resources now to get an investment return. Then the third thing is just a generic impatience that we would rather have pleasure earlier rather than later, because who knows? We might get hit by a bus tomorrow, so tomorrow might not come around for us to enjoy that consumption. Those are the three motives that are taking around in standard economic theory.

What that means is that what your savings rate should be is simply, what is the difference between what your income happens to be right now and what your consumption level should be, given those three motives I described. For most people, when you're in your early 20s and your mid-20s, your income is fairly low, relative to your lifetime income. In your 40s and 50s, those are your peak earnings years. Economic theory says, well, in your 20s, maybe you shouldn't save all that much, and so you should consumption smooth, save close to zero and consume close to everything that you have in terms of income. Then it's really in your 40s and 50s that you turn on the savings jets and become a super saver and make up for all those early years when you weren't saving much at all.

The obvious follow-up question, James, how does the actual behaviour of households differ from this economic theory?

Households do behave in some ways, a lot like that, in that there are a lot of people that just don't save it all in their 20s and in the 30s. Then you do see a great increase in savings on average in your 40s and 50s. In that respect, households do qualitatively seem to follow that pattern. Now, the question is, why do they do that? Is it because they're rationally consumption smoothing, or just that they can't control themselves in their 20s, and so they just spend up to the hilt. Then the 40s, they're like, “Oh, my gosh. My financial life's a wreck. I need to get on the ball and have something saved up for retirement.” That's when they start saving, just like the student who starts cramming for the tests just before the test is about to be given.

I think one area where economic theory has a hard time matching what happens with real life people is that there are a lot of people that have no emergency savings buffer, so no rainy-day savings. Economic theory tends to recommend that you should have that three months, or six months of expenses saved up. Even in your 20s, you should work really hard to build that up really fast, because life becomes fairly unpleasant if you don't have that buffer, because there's just stuff that happens. You don't know exactly what it's going to be, but it's going to be something.

You see a lot of people who live without that cushion. You see a lot more credit card borrowing than economic theory would predict that people should do. In that respect, people may indeed be not saving in their 20s, not because they're rationally and forward-lookingly consumption smoothing, but just they can't control themselves. They overspend and they maybe mismanage their financial lives in that way.

How does popular personal finance advice on saving and spending differ from economic theory?

I talked about consumption smoothing as being a predominant motive in economic theories for these popular personal finance authors, they're really up to savings rate smoothing. Rather than having those consistent level of spending over time, they say, you should save a consistent percentage of your income over time. Something like 10% to 15% through thick and thin, no matter what, no matter how old you are, no matter how hard times are, you should be really aimed to have that consistent percentage of saving.

I think the view there is one that compound interest is really powerful, so the right time to start saving is now, no matter when now is. Now, economic theory takes that into account also, and says, even with the power of compound interest, maybe it's just not worth it for you to save very much in your 20s. For the popular authors, it's really, now is always the right time to be saving 10% to 15%.

The second reason, which I think is really interesting, is this notion that saving is a virtue. It's a habit. The only way you build this virtue of this habit is to practice it consistently. A very Aristotelian point of view that you build these virtues by doing them. There's one author in particular, I can think of, who says that if you have spent your 20s and 30s not saving, it's just not psychologically realistic, but you're going to be able to become a super saver in your 40s, so you better start saving now.

Interesting. Who do you think has more to learn from the other on savings and consumption? The economists, or the popular personal finance authors?

Hard to say. I think that there are elements of truth in both. The way that some of these popular authors describe — like even if you are unemployed, or you're going through a real rough stretch, you just got to keep on saving. Actually, if you're unemployed, that's probably a pretty good time to be dissaving and can draw down in the nest egg and make things a little – more pleasant for yourself. I think consumption smoothing is important. It's a real thing that people should take into account. On the other hand, I think there is, as we all know, limited ability to stick to a plan, to be motivated. This notion that maybe it is hard to start living really within your means, live in fact, far below your means at a certain point in time, and to just start doing that in your 40s when you've never done it before in your life, maybe that's actually really hard.

I think that that is a force that hasn't really been studied in economics, but I think it's quite plausibly a real one and quite plausibly just a first-order consideration, where if you had a child in their 20s say, “Oh, yeah. Go ahead and have $30,000 credit card debt.” Your consumption smoothing is no big deal. Gosh, I would actually have some discomfort in recommending that to my child, because it does feel like an improved and unwise way to live, even if the economic model says, “Yeah, no big deal.”

What does economic theory suggest about optimal equity allocations for households through the lifecycle?

Economic theory loves stocks. Just love, love love stocks. The fact that people don't have as much stock as economic theory says they should is one facet of what's known as the equity premium puzzle. Stocks have been this fantastic deal historically, just anomalously fantastic, but it's just not clear why they're offering such a high out of return, given that the risks are actually not that large. Usually, we talk about equity premium puzzle in the context of just what I think of as institutional portfolio, where you just have a pot of money, you're trying to invest it, and there's no other income, or resources coming your way.

For real-life people, almost all of us are not in that situation, so we have a nest egg that we're investing, but then there's labour income that's coming in. For the vast majority of people during most of their working life, the biggest asset they have, the biggest economic asset they have is their future labour income. You might call that their human capital. Now, how does this human capital behave? It's actually a lot like a bond. It's the interest payments, which are your salary. Pretty stable. Doesn't have a ton of correlation with the stock market. Has a little bit of correlation, but not a ton of correlation.

It's like, you have this enormous fixed income position in your overall wealth portfolio that's embodied in your human capital, and your financial portfolio, which is what you're thinking about investing, or allocating from an asset allocation perspective. It's like a tiny sliver of your overall wealth portfolio. Because you have this huge fixed income position in your human capital, you can take a lot of risks. In fact, you should take a lot of risks with your financial portfolio, and that means that even into your 40 to 50s, some of these models say, a 100% equities is the way to go, and you don't really see that a lot in say, the target date retirement funds, or the other portfolio advice out there, or a 100% equity seems crazy.

Maybe you should dial back to 90%, or 80%. But the economic theory would say, “Look, you got to have a broader view here.” We would agree that as you're older, you do want to become more conservative, because you have less human capital left, because you're just a fewer wage payments coming to you in the future. As your implicit fixed income position decreases with age, then you should be increasing the fixed income portion of your financial portfolio, but that doesn't really kick in for somebody with reasonable levels of risk aversion until quite late in working life. That's the tension between what you see in practice, what you even see in these popular personal finance books, versus what the vanilla economic theory would prescribe.

Yeah, let's dig into that a bit. How does popular personal finance and equity share differ from theory?

They end up in similar places qualitatively. When it all is said and done, I think the popular personal finance books recommend a hump-shaped equity share over a life cycle, and the standard economic theory would end up somewhere close to that as well. You just have a level shift where standard economic theory would recommend more equities than the popular authors do. Then there's a difference in the reasoning why you get to your conclusion.

The economic theory, I just described the reasoning why it gives you the recommendation that does. For popular authors, there's this really strong sense that stocks become less risky as the investment horizon increases. Actually, if you look at the data, it's really hard to find evidence that that's true. You look at the annualized standard deviation of the S&P 500 in the post-war period, and you just change the holding period from one year to three years, to five years, to 10 years, the annualized standard deviation is pretty flat.

This notion that the stock market mean reverse is just not there very strongly in the data at all. Then, there was this very famous theorem that was independently proven by Nobel Laureates Paul Samuelson and Bob Merton, I think it goes back in the late 60s that they published these papers independently, that shows that if, indeed, stock returns are like that, that they have an annualized standard deviation that doesn't change as the investment horizon increases and more exactly speaking, it's true that every year the stock return this year doesn't really depend at all on the stock return in the prior year, then your asset allocation optimally should not change as your investment horizon increases, or decreases. It's a fairly counterintuitive result, but it's just standard theoretical result in the finance literature.

Popular authors say, “No, no, no. Actually, it is the case that the longer you hold the stock, the stock market, the less risky it becomes.” The way they justify this is they say, look, historically, and this is absolutely true. As the length of time you hold the market increases, the likelihood that you are going to underperform the risk-free bond decreases. Voila, you should actually hold more stock as your investment horizon increases.

Now, that's taking a fairly simple view of risk, which is the risk hasn't paid off if the stock investment has underperformed the bond investment, which is very intuitive, in fact, and seems to make a lot of sense. The reason economists rejected that criterion is it actually matters by how much you underperform the bond. It's not just a 1-0, you've underperformed or not. As the investment horizon increases, it is true that the likelihood that you're going to outperform the bond in the stock investment does increase. The worst-case scenario also gets worse and worse and worse, or the worst-case possible scenario gets worse and worse and worse as the investment horizon increases. It turns out that those two forces exactly offset each other. That's the economic theory.

Just to finish up on the popular authors, because they think that stock investments are less risky as time goes on, they say, you should bucket your money according to when you think you're going to spend it. Any money that you're going to spend in the near term, and near term could be as long as in the next 10 years, the most extreme, but the median author would say something like, in the next five years. You're going to spend that money in the next five years, that should be all in cash. Because stock market is too risky for any money that's earmarked for a shorter spending horizon.

Then it's this money that you don't think you're going to spend for a long time, that's the money that you should think about putting into the stock market. There are some authors that use some variant of the 100 minus age rule. You should have a 100 minus your age percent of your long-term money in the stock market. There are the authors that say that any money that you're not going to spend in the near term should be invested in the stock market. It's a very horizon, or investment horizon-driven advice that's out there.

Super interesting. The difference between thinking about the variance of the outcome and the probability of beating a benchmark, driving the difference in recommendations, that's a really interesting way to explain it. That is the way to explain it. You explained it well though.

Thank you.

Very good. By the way, I love this research. We did speak with Adriana Robertson a while ago. We touched on this briefly with her, too, but how does what people say about how they choose their equity share differ from theory?

By the way, Adriana Robertson and I go back a long way. She was a PhD student at Yale and we wrote a couple papers together, just where we were asking individuals how do you make various financial choices? That's the call back, for listeners who don't know, what is this connection with James Choi and Adriana Robertson? She's fantastic. A real superstar.

Just to get back to your question, I think that there are a lot of the standard considerations that we have in our theories that people say are important. Then there are things that people say that aren't really in our economic theories. I don't want to think about my finances. I just don't have any stock investments. I don't like thinking about it. In economic theory, there's no such thing as not thinking about it. Everybody's thinking about their financial portfolio. They come to a choice, but you might not agree with it, but they're thinking about it.

I think this notion of finance phobia, discomfort with the market, I think people are going to rip me off. Those are pretty important factors. I think that that is important. I know a fairly famous economist who we were just having a conversation a few months ago, she was a refugee as a child. She escaped to the West as a refugee. Her childhood was characterized by a lot of financial deprivation. She still has a lot of feelings of trauma around finances, such that, I mean, she's, as I said, fairly famous now. I'm sure very well compensated. Her retirement plan administrator made some mistake. They put her in the wrong target date retirement fund. They thought that she was going to retire imminently, something like that. She was much more conservative than she should have been in her retirement portfolio.

She just could not bring herself to call the plan administrator and say, “Look, there's been a mistake. Can you reallocate me to the PDRF with retirement date that is appropriate for me?” You think that's a very simple thing to do. She just couldn't do it emotionally, which I thought was quite striking. I think that a lot of people do carry around these feelings of PTSD around finances, because let's face it, for a lot of people, I love thinking about finances. I love thinking about my finances, just because I'm a nerd like that. I think for a lot of people, this is just an area of a pain, of anxiety. They would rather just not deal with it.

How did your survey research change your perspective on equity share?

There are those kinds of considerations outside of a theory that I think made a difference. I think there was another response that I thought was quite interesting, which was people said that the risk that we're going to enter, basically, another great depression, or something comparable to that was a fairly important driver for their portfolio shared equities. Now, this has been a theory that's been kicking around academic finance for a while.

As I said before, equities are a curiously good deal. It's a mystery why people don't have a lot more equities than they do. This theory arose called the rare disaster theory that said, really, people are concerned about these once in every 100 years disasters. That's why they're not holding equities. By the way, you just compute the historical average return and risk to the stock market, while rare disasters being rare, you just don't see in the historical data the rare disaster having happened. That just because you’ve gotten lucky. In fact, stocks are a lot riskier than it might seem from just looking at historical data.

Okay, so that helps us explain a lot of phenomena out there. Rare disasters being rare, this theory is also conveniently very hard to falsify with data. Here's a cute theory. It conveniently explains stuff, but since it's so hard to falsify, I don't really know how much I should believe in that theory. Here's another source of data that we can use to corroborate that theory, which is do people in fact say that they're afraid of another great depression? A lot of people say that they are and they say that it affected their portfolio share and equities. And so, I actually updated my beliefs on the possibility that that theory is actually an important driver of some of these financial phenomena and choices that we see in the market.

Those two papers were just incredible. We talked to Will Goetzmann recently and they've got a paper like that, that they looked at Robert Schiller's survey data going back in 1989 and they found the same thing that people are really worried about this stuff.

Will is my colleague at Yale. He's done some fascinating work, too, on survivorship bias in stock markets, where we look at the US market, or the Canadian market, or whatever and say, “Oh, my gosh. Fantastic average returns over the last century.” We forget that, well there was the Russian stock market that shut down and went to zero. We just wiped them from our data, because we're not living there. We're not invested in that stuff. The possibility that the same thing could have happened in the US and Canada, it just didn't. We're the lucky beneficiaries of having had some good luck.

Very true. I want to ask about a paper that is not out yet, just the abstracts on your website. It's hopefully not too much to ask. How can households apply economic theory to their own asset allocation decisions without needing to solve a complex, dynamic programming problem?

This is a paper that I'm writing with a couple of Yale PhD students, finance PhD students, Pengcheng Liu and Canyao Liu. This gets back to the earlier discussion we were having about what fraction of your portfolio should be in stocks? It turns out that standard theory says it should be a lot. The reason is that you have all this human capital that's coming to you. Now, the first paper that demonstrated that was published in, I think, 2004. You can't actually come up with a compact, nice formula to tell you what fraction of your portfolio should be in equities in that setting where you have labour income coming to you that you can't borrow against, you can't hedge, and so on.

What they do is they write a bunch of Fortran code, honestly, to solve what's called a dynamic programming problem. The computer spits out some numbers saying, “Okay, under these scenarios, you should have a 100% equities, or 89% equities, or whatever.” They solve this model for one set of parameters and they show you a graph saying, this is what your portfolio share and equity should look like over the course of your life cycle. Okay, that's great, but they solved for one particular set of parameters. Then here I am sitting here in New Haven, Connecticut, trying to think, “How am I going to teach this to my MBA students who don't have the same parameters that the authors of this paper use to run their program on?”

Well, I could say to the MBA students, “This is a solution that doesn't apply to you, but it's nice to look at.” That's not very useful. Or I could say, “Well, you yourself can go and write some code to solve this dynamic programming problem.” They're not going to do that. Even economists don't do that. I don't talk to a single economist. That's a little bit of a hobby of mine. Just ask economists, famous economists, how did you make your financial decisions for yourself? None of them have ever said, “I wrote down the dynamic programming problem. I wrote some Fortran code, or map lab code and I solved it out.” Nobody does that.

The question is, can we find a way to figure out the solutions to these complex models without requiring people to write their own Fortran code, and in a way, it's simple enough that an MBA student with this spreadsheet could easily do the calculation and it's flexible enough that it's accurate, reasonably accurate over a wide set of reasonable parameters. That's the project that I'm undertaking with these two PhD students to try to come up with good approximations to these numerical solutions that can be calculated in Excel with just a little bit of work. Not something that the typical person off the street could necessarily do, but something that a reasonably MBA student could do fairly easily.

Super interesting. Is it promising? Do you think they'll be able to come up with formulas?

I think we're getting close to having that first draft written. We're able to get a fairly close fit with the numerical model solutions with the simple formulas that were, I should say, simple-ish formulas that we came up with. But just basically, an NPD problem. It all just comes down to how do I calculate the present discounted value of my human capital? Then the important input there is what is the discount rate that I'm going to use with our human capital? Once you figure the discount rate out, it's all simple, but it's just getting to that process that's a little complicated.

The reason that this project has taken a long time is I've discovered that these numerical solutions that come out of these models that can't be solved just with paper and pencil, they're actually fragile. You try to replicate the results from the old papers and you find, “Oh, my gosh. Actually, I'm not getting the same results that they are, so it's push this and push this and push this.” It turns out that some of these results are fairly sensitive to assumptions that you think shouldn't really matter that much. There's this really fascinating paper that was published, or accepted for publication recently called Non-Standard Errors, where literally, a ton of authors in this paper and they just asked a bunch of different independent research teams, 'Here's the question, here's the data set, give us the answer to this question.' The answer that they came from the same data set, the same question, very quite a bit across research teams and said –

Wow.

- it is a little disturbing that researcher discretion plays a fairly big role in the answers that come out, even from very, very defined questions, the same data set. I think this is a version of that where you try to solve a model, you write the code, and then at some point you say, this is good enough, and who knows exactly how close different teams would get to that solution, the same solution.

Fascinating. Why do many households fail to participate in the stock market at all?

That's been a question that's been explored for a long time in the literature as well. I think a big part of it is a lot of households don't like to think about their finances. Investing in the stock market takes a little bit of energy, a little bit of thinking, a little bit of effort. I think that there are a bunch of households out there that think, “That's not something I want to deal with.” I think there's a significant fraction of households that think they don't have enough money to make it worthwhile to invest in the stock market, and sometimes that can be sensible.

If you have a $5 investment in the stock market, honestly, it's not going to help you all that much. If it costs you $10 of effort, and you only have $5 to invest, yeah, you shouldn't be in the stock market. I think that's a fairly big factor for a bunch of people. I think there's a lot of mistrust in the market. I refer earlier to the fear that a lot of people have, that they're going to be ripped off by market participants. I think that's a big deterrent as well. I think the other standard stuff about, I'm afraid of the great depression and that sort of thing. It also comes into play. I think, probably three things that I would really highlight are mistrust in the market, not having enough money to invest in, and then just not liken to think about your finances.

Yeah, that's the finance phobia that you mentioned earlier. How does non-participation line up with economic theory?

Standard, plain vanilla economic theory says that everybody should have at least a little bit in the stock market. That's why non-participation has been labelled a puzzle. Now, the fact is that a lot of people don't invest in the stock market, and it turns out that the rate in which people don't invest in the stock market decreases with wealth. That's why this fixed cost of investing theory has been fairly prominent, that if it costs you a $100 of effort in hassle costs and whatever to invest in the stock market, then if you only have $1,000 to invest in the stock market, then it's just not going to be worth it. As you get more and more money, it's going to be more worthwhile for you to pay that fixed cost and to initiate that stock market investment.

Now, there are some important short fawns of that theory, most importantly being that even if you look at say, the top 5% of the wealth distribution, there are a bunch of people up there that aren't investing in the stock market. It's really hard to think the fixed cost are so big that someone in the top 5% of the wealth distribution wouldn't find it worthwhile to invest in the stock market. There, I think that some mistrusts that could be playing a role, the fear of the Great Depression, that could be playing a role –

One thing that I should have mentioned in response to your earlier question, which I think wouldn't necessarily apply to people in the top 5% of the wealth distribution, but certainly for somebody lower down the wealth distribution, this notion that any money that I might spend, say in the next five years should not be in the stock market. Well, for a lot of people, all the money that they have is at least at some probability, it's going to get spent in the next five years. They might think, “I just shouldn't be putting any of this money in the stock market.”

Why do investors continue to allocate to actively manage funds, despite all the theory and all the evidence suggesting that decision is suboptimal?

I think that there's a bunch of ignorance of the investing results on average. It just makes sense that you put this money with professionals, they're going to do a better job. Among those who do know the facts about the average results of active investing, versus passive investing, I think, who's going to go with the average fund manager? I think it was Oscar Wilde that said, that my tasters are very simple. I'm easily satisfied with the best, so I'm going to go with the best manager that I can go with the average schmo, who is managing money.

It seems fairly intuitive how you find the best fund manager. You look for somebody who's at very high tax returns, because in most domains in life, you look for somebody who's done really well in the past, they're probably going to be better in the future. It just so happens in the fund management domain. That intuition breaks down, but it's one of those fairly rare domains in life where that intuition does break down. I think it's very sensible for people to follow that return chasing strategy. That's my theory on why active management remains

In your survey research, what do people say about why they invest in active funds?

They say, they think they're going to get a higher average return by going with active funds and then advice from an investment advisor is also fairly important. It's not anything mind-blowingly surprising, but there are some economic theories that say, people invest with actively managed funds, knowing that they're not going to actually get a higher than average return for various complex reasons, but they're happy to do it. What the survey suggests is like, no, they think they're going to do better.

What does popular personal finance advice say about active management?

Mostly, they're onboard with the indexing revolution. They say that it's really hard to pick winning fund managers, and so you should go passive. Not all of them say that, but most of them say that.

What do you think needs to happen for more investors to understand the benefits of low-cost index funds?

It's happening slowly. Knowledge infuses slowly on the scale of decades. You are seeing indexing rise with time. It's hard to convince people of stuff. It's hard to teach people stuff, and so so this gets to, as I was saying with my Yale MBA students, you teach them the stuff in class, and then you look at the portfolio and it's like, “Oh, my gosh. The portfolios actually having very little resemblance to what we taught you to do in our core classes.” Even Yale MBA students aren't quite convinced by this expensive education that they're paying to get, then for the ordinary individual, this is not really the top priority of their life to be thinking about this and be learning about this. It'll just take time.

There are these countervailing forces, too, with quasi-passive strategies, like smart beta, where it's like, “Oh, this seems like a fairly good idea.” It's really active management under different a guise. I think that could be another force that slows the migration into truly passive strategies.

That's an interesting point. You said that you like to ask famous economists about how they arrived at their asset allocation decisions. Do you have a sense of how famous economists tend to invest their money? Are they investing in index funds?

I think it might have been Bill Sharpe, one of the economists who want to know about prize for his work on financial portfolio theory. He was asked, how did you choose between stocks and bonds? He said, “I went 50-50, because I didn't want to regret my portfolio choice.” He did not follow his own theory in making these decisions. I've heard a bunch of economists say, “There was this default asset allocation that was in my retirement savings plan. They got swept up with automatic enrolment in the plan, and I'm still at the default all these years later.”

There are other economists that say, “I'm a 100% stocks. I'm just betting on the equity premium, because there's this equity premium puzzle. Stocks have been an enormously good deal. Betting with this is actually a mistake on the part of the market, on part of investors, and so I'm a 100% equities.” There are other famous, famous economists that say, “I hold no stocks, whatsoever.” I say, “But you know that's a mistake.” They say, “I'm a behavioural economist. I'm a loss averse.” But loss averse is a mistake. None of it. This is the way I feel. Very, very famous economists, like really at the top of the profession who just have all their money sitting in cash, which I guess, they make enough money that it’s fine for them. Not what I would recommend for your listeners.

Unreal. I think it was Markowitz that said the 50% in stocks, 50% in bonds to minimize regret. What about diversification? Why do you think households hold under-diversified portfolios when we know diversification usually makes sense?

Part of it I think is this notion that I know better, that I'm going to be able to pick the winning stocks. Rather than putting my eggs in many baskets, I'm going to just put all my eggs in one basket and watch it very, very, very closely. It is, I think, this illusion of control and of being able to predict this process, which is very, very hard to predict, is a big part of it. I think another thing that you see is that there's this broader phenomenon called home bias, which works on many, many different levels.

At the broadest level, people tend to overinvest in the stocks of their own country. Then within their country, they tend to overinvest in stocks in their own region. Then they also have this tendency to overinvest in the stock of the company in which they work. Things that are familiar seem less risky to us. We also tend to ascribe to them as having higher expected returns, and so there's this familiarity bias that makes under-diversification also feel less scary and wiser than it actually is.

Is that how households explain their concentrated equity holdings?

We asked these high-net-worth households, million-plus dollars and they do tend to think that these are just good deals that they are going to get a higher average return with less risk by holding onto these concentrated positions.

That response to the survey was – so many of the responses were incredible, but that one was just fascinating.

It's incredible to an economist, but I think for an ordinary person, of course, this is the most natural thing in the world.

It's still incredible. It's so wrong. What does the popular personal finance advice say about diversification?

On the individual stock front, I think they tend with some exceptions, to advocate for diversification. Some of them are more permissive, like you can maybe take 20% of your portfolio and have it invested in the stock of your own company. That's okay if you feel good about the company, which is far above what economists would say is a good idea. Generally, they're in favour of diversification. I think on the cross-country stock allocation, it's quite interesting. They are fairly home biased in their international recommendations.

On average, I think it was about 30% of one's portfolio that they would recommend being overseas. This is for a US audience. 30% is far less than the global market cap weight of non-US stocks relative to US stocks. They say, yeah, you should diversify internationally for the most part, but a lot less than the market cap share of international stocks. Just the plain vanilla finance theory without any frictions, or other considerations would say, you should be holding all the stuff in proportion to their market cap.

What did investors learn about diversification when Enron employees lost everything by investing in 401ks in their employer stock?

Not a whole lot is what it seems like. Maybe it was a little bit of movement, but I think there's been a bunch of emerging evidence in behavioural economics that we just need to experience things for ourselves to really learn. When something happens to somebody else, you learn a little bit from it, but not all that much. Living through a bear market is very different than meeting about a bear market. Even if it's from the data generating perspective, it's just as relevant for your belief formation, or it should be just as relevant for your belief formation if you have read about a bear market that happened a little bit before you were born, versus you actually lived through the thing.

Fascinating work that was done by Gautam Rao at Harvard and many other co-authors, where they ran an experiment where you were trying to guess how many red balls are in this jar. You're just drawing balls from the jar and you draw five balls, or 10 balls and then you make a bet on what percent of the balls, they are in a red versus, say green. It turns out that if you draw the balls with your own hand, you actually update your beliefs more than if you watch somebody –

Come on.

- else in the same room draw the balls. You see the ball in their hands, you just learn less, when somebody else is reaching into the urn and drawing the ball. It's a very, very –

Come on.

- strong phenomenon that we just need to learn and experience it for ourselves. Of course, with our children and other young people, you see them making the same mistakes that we made, but they just need to make mistakes for themselves.

Crazy. That makes me think about risk tolerance questionnaires, trying to think about how much risk an investor should take. I remember Ken French saying to us that you can learn a lot about yourself in a bear market. Sounds like that might be very true.

That's a really interesting thing that came up in some of the popular finance books I read too, which is this notion that you don't actually know what your risk aversion is. In standard economic theory, everyone knows what the risk aversion is and they're just optimizing their portfolios against that. It's like, no, you don't actually know what your risk aversion is, and so you actually need to live through a bear market. Maybe you shouldn't actually be 100% stocks before you live through a bear market, because you don't know what your risk tolerance is. Everyone thinks they're going to be really courageous until they're actually in the foxhole. I thought that was a pretty interesting perspective to have.

Another interesting difference is just the definition. I've seen a lot in industry, risk tolerance surveys as well. To define risk tolerance as the ability not to sell in a bear market. That's not what economists would say risk tolerance is. We'd say that risk tolerance means that the value of extra dollar to you doesn't diminish very quickly as you get richer and richer and richer. But ordinary people don't think in those terms. I think they really do think in terms of the emotions. Am I going to sell out when my stock position drops 20%?

You told this story briefly earlier about the behavioural economist who was loss averse and making a mistake, but knew he was making a mistake and was happy about it.

I don't think he thought he was making a mistake.

Okay.

I think he thought, loss averse is a real thing and it makes me scared to be in stock market, and so I'm just not going to be in the stock market.

How do we generalize from that? How do we differentiate between mistakes and a behaviour that makes sense for a person for some unobserved reason?

When your kid says that he wants to eat another piece of cake and he's really, really upset when you don't let him, was that a mistake? It's a real thing that he feels pain when he's not allowed to have that other piece of cake. There is a level of paternalism that could come in and we think it's quite appropriate when we don't let our five-year-old eat that third piece of cake. Trickier when it comes to adults. That's, of course, been a big dividing line in politics for a long time.

Exactly how much paternalism should we impose on people, versus just letting them choose for themselves and enjoy freedom and possibly experience the negative consequences of that freedom, but that's just a value, a non-consequential value that we attach to liberty. That's not a question that we're going to answer today, but I think it's a deep, philosophical one.

Why do investors invest in high-fee index funds when lower fee options are out there?

I think there's ignorance. One of the interesting pieces of research that has come out in the past decade or so is just the role of financial advisors and financial advisors, they do a lot of things. I think a big part of it is creating trust, creating comfort with taking on risks. This nice financial advisor who's been with you through thick or thin says, this is a great fund to invest in and yeah, it's going to charge you 90 basis points to index the S&P 500, but that's not really mentioned, or it's mentioned in passing. You're like, “Yeah. I'm happy to go with that.”

I think that's probably a big part of what drives these really, really high-fee index funds and even actively managed funds to continue to exist, that role of the financial advisor. Now, if I were the defence attorney, or the financial advising industry, I'd say, “Look, this might not be the best thing for individuals, but it was better than what they would have done without the financial advisor,” because then they would have just been like, these behavioural economists have told you about if you have all their money in cash, yeah, they should be in stocks. If it takes paying 90 basis points per year on fees to do that, because you need to compensate the financial advisor who holds your hand and makes you comfortable with taking on those risks, so be it.

Do you change the oil in your own car? “No. I take it to the mechanic and the mechanic charges me a whole bunch of money.” You can say, “Oh, that was a rip off. You fool. You should have just changed the oil yourself and saved a lot of money, but no. It's actually a good thing that I can get some other person to change my oil for me.” That would be the defence I would give for the defence attorney for the financial advising industry. I think there's that.

Then really interesting, you ask people about their financial advisors in surveys, large-scale surveys, what do you value about your financial advisor? You would think from an economic perspective that what they really value is the portfolio performance that the advisor brings to you. Actually, people don't say that's important. Hardly at all. They say, the most important thing about my financial advisor is he or she listens to me, is responsive to my needs, that sort of thing. Portfolio performance is way, way down on the list of things that they value. It does suggest that these folks are doing something different than what we might have thought they are really doing.

You got another really interesting empirical paper on people not taking advantage of employer matching in their 401k plans. I'm going to skip asking you about that, but I think your finding is that they're making a mistake by not contributing. In those two cases of the high-fee funds and not taking advantage of employer matching, how well does education resolve the mistakes?

It moves the needle, but not by a whole lot. This gets back to my own modesty and what is the role of me as an educator in actually changing behaviour? It makes a difference in the way that you would expect, but it's not like people go all the way to where you think they should be based upon your education, so people, we tell them these are the fees and these S&P 500 index funds, did you know that they all offer you the same portfolio return before fees, that sort of thing? I mean, they choose cheaper funds, but not all the way. I think they take your advice to a certain extent, but then they mix that with whatever they were going to do anyway.

How does past personal experience with investment returns affect future saving decisions?

That goes back to our earlier discussion of just making a huge difference, if you experience something personally or not. I had a very early paper in this line of literature that's now really exploded, where we found that if you had a particularly favourable return in your 401k, your 401k retirement savings plan, then you become more likely to increase your contribution rate to the 401k in the following year, and that's comparing you versus somebody else who had exactly the same asset allocation from a high level asset class perspective, but they just happen to be invested in different equity funds, let's say. And so, they happen to have a less favourable return than you, then you will increase your contribution to your 401k more than your co-worker would.

That's that earlier thing, but then, Stefan Nagel and many others have shown that living through stock market returns are favourable cause you to just over your life, invest more in stocks going forward. They've also shown with governors of central banks that if they live through high inflation times personally, then they're more hawkish on inflation than those who haven't. These personal experience effects are pretty pervasive, even among people that we will think of as experts, as federal reserve governors, for example.

Wow. You touched on it briefly, but what role do you think financial advice can play in improving financial decisions?

I think it makes a difference on the margin, as I said. Just the education does move you in the direction that you think. A lot of people do use professional financial advisors, and they probably do move people in a direction that's better than where they were without the financial advisor. It comes with all sorts of complications and conflicts of interest and the advisors believe in things that economists would say are not true. I think that the financial advisors generally, I think, the finding is that they're not necessarily liars, or people without integrity. Some of them are, but I think for the most part, they're true believers.

You look at their personal portfolios and this was from Canadian data, I think. They invest consistently with their own advice, so they too, are investing in these high fee funds in the personal portfolios. They even invest in those same funds after they have left the advising industry. You can still look at their portfolios. They're still true believers.

What interventions do you think are most promising for improving the behaviour of households?

I think it's going to be a combination of things. There's been a lot of emphasis in policies recalled over in the last 15-20 years on automaticity, so then defaulting people into certain kinds of choices. You have to opt out of saving and retirement, rather than opt in. We're going to automatically escalate your contribution rate to the retirement savings plan over time. We're going to default you completely into a target date retirement fund in your asset allocation in the retirement savings plan. That's been a big thing. Not just North America, but globally.

I think that we need to be appropriately modest about what these sorts of interventions are going to do. On the one hand, they're very cheap to implement and they do move a lot of people in the direction that we think that they're going to move, that we want them to move in, but there are all sorts of margins on which people adjust. It's like, yeah, we got to eat the salad for lunch, but that means you pig out dinner. I think you see some of that behaviour as well in these financial domains, where we nudge you to save more in your retirement account. It turns out that maybe you borrow a little bit more, or you take a bunch of the money out when you transition jobs. In the US, you can access your 401k, retirement savings money pretty easily at a fairly low fee, low penalty fee once you leave your job.

There are all these margins of offset that we need to be aware of, and it's just be modest that we probably are not going to nudge our way to financial salvation. It wouldn't make things a little better, but honestly, maybe I'll get in trouble someday when I'm in my static confirmation hearing or something for saying this. But I have gained more sympathy over the years to these forced savings mechanisms, like what you have in Singapore, or Australia where it's like, “Look, we're just going to take 15% of your income, no matter what. We're just going to put it into this really illiquid retirement savings account. You can take it out for certain purposes. But for the most part, this is just locked up.”

Really paternalistic. Surely it hurts a bunch of people who economic theory says, should be consumption smoothing, so shouldn't be saving on that much in their 20s. But if you look at in most advanced developed countries, in what form does the middle-class actually accumulate any non-trivial amount of wealth? It’s almost all in these highly illiquid forms, like housing, like retirement savings accounts. Maybe that's really the only way you can get a whole bunch of the society to really accumulate a significant amount of money over the course of the life cycle.

You've got interesting stuff on that, too. That's the wealthy hand-to-mouth concept, right? Where people accumulate illiquid assets, but not liquid assets?

That's not research that I've done a lot directly, although I do look at what these popular personal finance authors say about being wealthy hand-to-mouth. They say, it's a bad idea to be cash poor, house rich. But you do see this phenomenon around the world. I can't remember if there was data in this paper from Canada, but certainly in the US. A lot of people of you are living paycheque-to-paycheque, even though they have significant assets that are in illiquid form, kind of form of a house, or retirement savings plan.

The question is, what's going on with these people? Because these aren't the type of people that we traditionally would have thought of as living paycheque-to-paycheque. They have a lot of money, a lot of assets, actually, but they're running out of money at the end of every month. One view is that that's actually an optimal choice for them. They're running such high returns on their illiquid assets that it's worth it for them to be paycheque-to-paycheque outside of those illiquid assets.

Another point of view is look, these people are just out of control. They have salted away some money in their house. That's a good thing, because it's forcing them to accumulate some assets, but they’re just out of control. They can't restrain themselves outside and they're making a mistake.

That self-control argument, I find very interesting. I heard you talk about it. It might have been on the Freakonomics Podcast that you did about how you're a renter. We've talked a lot about renting versus owning a home on our podcast and that's one of the common counter arguments is that renters are just going to spend all their money.

I think that there are all sorts of things that we might do that are second best, or third best from some perspective. But once you take into account all the other constraints they're operating under, including motivational constraints, self-control constraints, then maybe it could make sense. I'm renting. I’m a renter for life, because I can't be bothered to deal with the hassles of owning. I think I'm pretty relaxed on general views.

Some people have read some media stories about my views where I'm like, “Oh, I'm a renter for life.” They're like, “Oh, you must be anti-owning.” No, I'm not anti-owning. I think that if you want to own a house and you get pleasure out of it and the type of place you want to live in is only really available to buy and you would really love to customize the place to your liking and etc., etc., yeah, you should own. I just don't think that there's this enormous financial penalty of any financial penalty at all to renting.

But subject to this caveat that if you really can't control yourself and you spend every dollar that's remaining in your checking account, unless it's pre-committed to mortgage, then maybe you should actually buy a place and build up some equity there. There's been some interesting research showing that this forced savings channel is real, that people do end up accumulating more assets if they are forced to pay their mortgage on a certain schedule. That said, I mean, home equity, it's not necessarily the best way to accumulate assets in the sense that if you ever need to tap it then, it's very expensive to tap, at least in the US the fees that are associated with it are pretty high and there's a big hassle cost. If you lose your job for example, then you suddenly can't get that home equity, line of credit because the bank looks at you and says, “Ah, you have no job. We don't think that you're credit worthy.” It's a just in the state of the world where you could really use that home equity. Like, “Ah-ah-ah. You can't access it.”

What do you think of the argument that owning a home hedges your future housing costs?

It does hedge your future housing costs, but there are other risks that come along with it. For example, your neighbourhood could go to pot. That's not hedging any future housing costs. Just your neighbourhood went to pot, your house is worth less. If you're to move, then you're just out of luck. It depends a lot on where you're going to move to next. If you're going to move in the same neighbourhood, for example, it's a reasonably good hedge. If you're going to move somewhere completely different where the housing cost is uncorrelated with, or you negatively correlated with your own housing cost, then it's a pretty bad hedge.

The other thing that has only been recently discovered in recent research is just the huge amount of idiosyncratic risk that is realized upon the transaction date. There's a huge amount of execution risk in housing transactions. Is it the case that when you happen to buy or sell, you come across a sympathetic counterparty that's willing to give you a good price. Huge element of luck that's involved there. A lot of it is out of your control. That's why you see that especially over short ownership spells, house can be quite risky because you have that huge matching risk, which counterparty are you matching up with when you're trying to buy or sell the thing?

What research is that? That sounds absolutely fascinating.

This is a paper by Marco Giacoletti, University of Southern California. He's been doing some stuff on housing, people who are flipping houses. Are they actually making a profit or not? Quite interesting. This is a paper, I think it was his dissertation out of Stanford, where he studied this question and he was looking at all the housing transactions in California. What is the annualized standard deviation of the housing return as a function of holding period? Turns out, the longer you hold the house, the lower the annualized standard deviation is of your financial return.

Then he looks at the why is that? The explanation he comes up with is this execution risk. If you bought the house today and sold tomorrow, then the only risk that you have is execution risk, because there's not been any time in between for the house price to fundamentally move. Anyway, that's his dissertation.

Really interesting. I'll have to look at that. In this area of practical finance of making economics useful for people, like what you're doing with the Yale personal finance class, what work of your own are you most excited about right now?

I'm pretty excited about that thing that I was working on with the two EL finance PhD students, to try to create something that's accessible to at least MBA students to figure out, what is the fraction of my portfolio that should be invested in stocks, given that I have this wage income stream that's going to come to me over the next few decades? We have dubbed that type of that genre of research as practical finance. It's kind of a marketing move to try to say, “Hey, look. This is a different kind of research that hasn't really been done too much within academic finance, to try to bridge that gap between highfalutin theory, versus something that an ordinary person who's reasonably numerate, could actually compute and use for themselves.”

We'll see where this goes. But hopefully, we'll just become more in the business as academic economists of creating research that is practically useful for individuals, versus here's this thing that's useful for institutional money managers, which is a valuable thing. We've done a lot of that. Or, here's this thing saying, “Ha, ha, ha. You're stupid. Let me tell you how. But not necessarily telling you how to fix it, or how you work around it, given that, yeah, you can't actually keep yourself motivated perfectly all the time.”

There's a lot more work that could be done there and trying to do something on helping people pay off their debts. That's a huge preoccupation for individuals, and you see in the popular personal finance books. If you ask an economist how you should pay off your debts, we don't have that much to say. Then we leave it to the Susie Orman's and the Dave Ramsey's and the Instagram influencers, or whatever to give that advice. “Hey, we should be in that business, because that's our domain.”

Fascinating. I love the term, practical finance. It's got a ring to it. Very good marketing.

Thank you.

Our final question, James. How do you define success in your life?

That's a lofty question, and so I have to give a lofty answer. I'm a Christian, and so I think that ultimately, it's about being who God is created you to be and to have a relationship with him and to love him and to love your neighbour, to love your family and to serve. As I think about my life, I think that I've been given certain talents and certain opportunities and certain platforms in which I can serve. As I think about even this practical finance research, or any of the other household finance research I've done, it's just about, how can I use these things to serve and to build knowledge, to discover, but also to help people?

The writer, David Brooks, talks about eulogy virtues versus resume virtues. Resume virtues being the thing that you put on LinkedIn and on your resume to try to get a job, and eulogy virtues being the things that people say about you at your funeral. His argument, which I think is correct is that we spend way too much time on our resume virtues and not enough time on our eulogy virtues. I'm trying to build my eulogy virtues more, so than my resume virtues. We'll see, hopefully in a few decades, not immediately, how successful I've been at that.

Great answer. James, it has been a fantastic conversation. Thanks a lot for joining us.

Thanks for having me. It was a lot of fun.

Yeah. Thanks, James. Incredible.

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James Choi — https://faculty.som.yale.edu/jameschoi/

'Behavioral Household Finance' — https://www.hbs.edu/ris/Publication%20Files/behavioral_household_finance_a3b33098-e0c7-40e0-bf2f-fa4ceb6e6d06.pdf

'Finance for the Rest of Us' — https://www.linkedin.com/posts/james-j-choi-finance_finance-for-the-rest-of-us-activity-6997910789097414656-5epq/?originalSubdomain=ba

'Popular Personal Financial Advice versus the Professors' — https://www.aeaweb.org/articles?id=10.1257/jep.36.4.167

'Millionaires Speak: What Drives Their Personal Investment Decisions?' — https://www.nber.org/papers/w27969

'What Matters to Individual Investors? Evidence from the Horse's Mouth' — https://onlinelibrary.wiley.com/doi/abs/10.1111/jofi.12895

'Are Empowerment and Education Enough? Underdiversification in 401(k) Plans' — https://www.jstor.org/stable/3805120

'Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds' — https://www.nber.org/papers/w12261

'$100 Bills on the Sidewalk: Suboptimal Investment in 401(k) Plans' — https://www.nber.org/papers/w11554