Beware of False Financial Advisers: Economic vs Financial Literacy

I’m all for financial literacy.

But I’m even more in favor of economic literacy. And no, the two do not always coincide. Here is a good example.

Dave Ramsey is a prominent financial literacy advocate. He also gives mountains of financial advice. But it is with articles like this that I wonder if he’s doing it right:

Dave Ramsey: How Teens Can Become Millionaires

The basic point: start investing and saving early (when you are 19). But what is wrong with this advice is that Ramsey never answers this question: What is the point of saving?

The accumulation of capital is not an end unto itself. Savings exists in order to smooth consumption over periods of high and low income. Ramsey only gets half that equation right in this example. He points out that by retirement age (the arbitrarily chosen 65), someone who invests $2,000 a year from the age of 19 to 26 can have half a million more than someone who invests $2,000 per year (assuming a 12% guaranteed return, an unheard of number). However, that ignores three realities:

1) Returns on investments are volatile and averaged year-over-year, so “compound interest” doesn’t apply to investment accounts in which you may lose part of your principle. In addition, risk-averse investments have smaller returns, so the gap is far smaller than his table has explained;

2) People are able to invest most during their prime working years (30-50) because they have more income to set aside;

and 3) 19 year-olds making good life decisions by investing in education usually do not have $2,000 per year in disposable income just sitting around. Most do not work, or if they do, they work in order to eat and develop a work and credit history.

If the 19-year old has $2,000 to save, it’s likely the result of parental gifts, which does very little to teach economic self-reliance and exacerbates the gulf between rich and poor later in life. Those whose parents are able to put away $2,000 a year in long-term investments for their children are probably going to pay for their educational expenses first rather than their retirement. Human capital is an investment too.

The Life Cycle

Students take on debt in order to eat despite their foregone earnings during their early twenties. They pay back this amount during their early thirties. Then in order to eat during years of zero working income (retirement), they save during peak career productivity.That $16,000 is a lot of important consumption to a college student, and often complements social and human capital accumulation that has far-reaching consequences. $2,000 per year to someone in prime working years may not feel like nearly as much of a hit. That is because the marginal utility (or the amount of use or happiness we get out of the next dollar we have) of consumption is higher when we have lower incomes.

Inexperienced young students may feel pressured into long-term retirement savings by older adults they look up to who seek to profit by incorporating a new segment of the population into the IRA market and expanding their investment portfolios. Advisers may ignore the immediate needs of the student and never clearly explain that there is a very real possibility that being slightly richer in retirement means having a miserable experience in your 20s.

An IRA doesn’t do a 20 year-old much good if they struggle in school, are unhealthy, or have to cash-out as a result of cutting consumption. But how many retirement advisers or life insurance salesmen are going to be straightforward enough to tell a student that they don’t need to contribute to an IRA right now?

Saving money now is foregone consumption, and that the marginal dollar is worth more to a college student’s standard of living that it is to a prime working age adult’s standard of living.

So yes, compound interest means that you may be able to have more in retirement if you save as a college student.

But economic literacy casts serious doubt on the the question of whether or not you should.


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