Episode 260: Prof. James Choi: Practical Finance

25:46So that's the economic theory. Just to kind of 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 and 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 kind of 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 the stock market's too risky for any money that's earmarked for a shorter spending horizon.

26:20And 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. And there are some authors that use some kind of variant of the 100 minus age rule. You should have 100 minus your age percent of your long-term money. In the stock market, there are other 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 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 there, that's a really interesting way to explain it.

27:00That 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 of papers together just where we were asking individuals, how do you make various financial choices? And so that's the callback for listeners who don't know, what is this connection with James Choi and Adriana Robertson?

27:34She's fantastic, a real superstar. So 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, but then there are things that people say that aren't really in our economic theories. Like, I don't like to think about my finances. And so I just don't have any stock investments because I 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.

28:09But 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. And 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. So she escaped to the West as a refugee. And so her childhood was characterized by a lot of financial deprivation. And so 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. And her retirement plan administrator made some kind of mistake.

28:52And so they put her in the wrong target date retirement fund. So they thought that she was going to retire imminently, something like that. So she was much more conservative than she should have been in her retirement portfolio. And 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 the retirement date that is appropriate for me? You'd think that's a very simple thing to do. She just couldn't do it emotionally, which I thought was quite striking. And 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.

29:32I love thinking about my finances just because I'm a nerd like that. But I think for a lot of people, this is just an area of pain, of anxiety, and 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 our theories 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 share in equities.

30:07Now, 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. And so it's kind of a mystery why people don't have a lot more equity than they do. And And so this theory kind of arose called the rare disaster theory that said, really, people are concerned about these once in every 100 years disasters. And that's why they're not holding equities. And by the way, you just compute the historical average return and risk to the stock market. Well, rare disasters being rare, you just don't see in the historical data the rare disaster having happened.

30:43That's just because it got lucky. And in fact, stocks are a lot riskier than it might seem from just looking at the historical data. Okay, so that helps us explain a lot of phenomena out there. But rare disasters being rare, this theory is also conveniently very hard to falsify with data. Here's a Q 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. But here's another source of data that we can kind of use to corroborate that theory, which is, do people in fact say that they're afraid of another Great Depression?

31:19And a lot of people say 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 Getzman recently, and they've got a paper like that, that they looked at Robert Schiller's survey data going back to 1989. They found the same kind of 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.

32:02And we forget that, well, oh, there was like the Russian stock market that shut down and went to zero. And we just wiped them from our data because we're not living there. We're not invested in that stuff. And so the possibility that the same thing could have happened in the US and Canada, it just didn't. And you were 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.

32:36This is a paper that I'm writing with a couple of Yale PhD students, finance PhD students, Peng Cheng Lu and San Yael Lu. This gets back to the earlier discussion we were having about what fraction of your portfolio should be in stocks. And it turns out that standard theory says it should be a lot. And 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. And 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 labor income coming to you that you can't borrow against, you can't hedge, and so on.

33:21So what they do is they write a bunch of Fortran code, honestly, to solve what's called a dynamic programming problem. And so the computer spits out some numbers saying, okay, under these scenarios, you should have 100 % equities or 89 % equities or whatever. And so 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 solve it for one particular set of parameters. And 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?

34:12Well, 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. And 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 MapLab code and I solved it out.

34:44Nobody does that. And so 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 that's simple enough that an MBA student with a spreadsheet could easily do the calculation, it is flexible enough that it's accurate, reasonably accurate over a wide set of kind of reasonable parameters. And so that's the project that I'm undertaking with these two PhD students to try to come 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 numerate MBA student could do fairly easily.

35:36Super 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. So 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. So it all just comes down to how do I calculate the present discounted value of my human capital? And then an important input there is what is the discount rate that I'm going to use for that 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.

36:15The 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 kind of fragile. You try to replicate the results from the old papers and you find, oh my gosh, like actually I'm not getting the same results that they are. So let's kind of push this and push this and push this. And it turns out that some of these results are fairly sensitive to assumptions that you think shouldn't really matter that much. And so there's this really fascinating paper that was published or accepted for publication recently called Non-Standard Errors, where literally like 100 authors in this paper.

36:56So 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. and the answer that they came from the same data set, the same question, like vary quite a bit across research teams. And so it is a little disturbing that researcher's discretion plays a fairly big role in the answers that come out, even from very, very defined questions of the same data set. And so 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, to the same solution.

37:40Fascinating. 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. And 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. So 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.

38:12And 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 invest, yeah, you shouldn't be in the stock market. So I think that's a fairly big factor for a bunch of people. I think there's a lot of mistrust in the market. So I referred earlier to the fear that a lot of people have that they're going to be ripped off by market participants. And so I think that's a big deterrent as well. I think the other standard stuff about I'm afraid of Great Depression and that sort of thing, it also comes into play.

38:48But I think probably three things that I would really highlight are mistrust in the market, not have enough money to invest in, and then just not liking 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 labeled 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 at which people don't invest in the stock market decreases with wealth.

39:25And so that's why this fixed cost of investing theory has been fairly prominent, that if it costs you like$100 of effort and 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 shortfalls 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.

40:02And so it's really hard to think the fixed costs are so big that someone in the top 5 % of the wealth distribution wouldn't find it worthwhile to invest in the stock market. And so there, I think that some of this mistrust, 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.

40:36Well, for a lot of people, all the money that they have is, at least at some probability, is going to get spent in the next five years. And so 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 managed funds despite all the theory and all the evidence suggesting that decision is suboptimal? So 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 facts about the average results of active investing versus passive investing, I think who's going to go with the average fund manager?

41:19I think it was Oscar Wilde that said that my tastes are very simple. I'm easily satisfied with the best. So I'm going to go with the best manager. I'm not going to go with the average schmo who's managing money. And it seems fairly intuitive how you find the best fund manager. You look for somebody who's had 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.

41:55And so I think it's very sensible for people to follow that return chasing strategy. That's kind of my theory on why active management remains very popular. 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 kind of 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.

42:37and 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 on board 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 effuses slowly on the kind of scale of decades. So you are seeing indexing rise with time, but it's hard to convince people of stuff.

43:14It's hard to teach people stuff. And 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 portfolios and it's like, oh my gosh, your portfolios actually have very little resemblance to what we taught you to do in our core classes. So if 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 to be learning about this. It'll just take time. There are kind of these countervailing forces too with quasi-passive strategies like smart beta, where it's like, oh, this seems like a fairly good idea.

43:57It's really active management under different guys. But I think that 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 Sharp. One of the economists who won a Nobel Prize for his work on financial portfolio theory. He was asked, how did you choose between stocks and bonds? And he said, I won 50-50 because I didn't want to kind of regret my portfolio choice.

44:37He 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. I got swept up with automatic enrollment in the plan, and I'm still at the default all these years later. There are other economists that say, I'm 100 % stocks. I'm just betting on the equity premium because there's this equity premium puzzle. Stocks have been an enormously good deal. And so I'm betting that this is actually a mistake on the part of the market, on the part of investors. And so I'm 100 % equities. There are other famous, famous economists that say, I hold no stocks whatsoever.

45:17I say, but you know, that's a mistake. I say, oh, you know, I'm a behavioral economist. I'm loss averse. But loss aversion is a mistake. No, no, but this is the way I feel. Very, very famous economists, 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?

45:56Part of it, I think, is this notion that I know better, that I'm going to be able to pick the winning stocks. And 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. So 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. So at the broadest level, people tend to overinvest in the stocks of their own country.

46:33And then within their country, they tend to overinvest in stocks in their own region. And then they also have this tendency to overinvest in the stock of the company in which they work. And things that are familiar seem less risky to us. And 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. So is that how households explain their concentrated equity holdings? So 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.

47:21That response in the survey was like, 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 kind of 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.

48:00But generally, they're in favor 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. And this is for a US audience. So 30 % is far less than the global market cap weight of non-US stocks relative to US stocks. So they say, yeah, you should diversify internationally for the most part, but a lot less than the market cap share of international stocks. And just the plain vanilla finance theory without any frictions or other considerations would say, you should be holding all this stuff in proportion to their market cap.

48:49What 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 behavioral economics that we just need to experience things for ourselves to really learn. And when something happens to somebody else, you learn a little bit from it, but not all that much. And so living through a bear market is very different than reading 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.

49:30If 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. And so you're just drawing balls from the jar and you draw like five balls or 10 balls, and then you make a bet on what percent of the balls in the urn are red versus say green it turns out that if you draw the ball with your own hand you actually update your beliefs more than if you watch somebody 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 so it's like a very very strong phenomenon that we just need to learn and experience it for ourselves and of course with our children and and other young people.

50:27You 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.

51:00But 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. And 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.

51:32And 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 that they really do think in terms of the emotions? And am I going to sell out when my stock position drops 20 %? You told the story briefly earlier about the behavioral 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. I think he thought loss aversion is a real thing and it makes me scared to be in the stock market.

52:10And 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 behavior 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. Is that a mistake? It's a real thing that he feels pain when he's not allowed to have that other piece of cake. And so 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.

52:45And so 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, kind of a non-consequential value that we attach to liberty. And so 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 has come out in the past decade or so is just the role of financial advisors.

53:28And financial advisors, they do a lot of things. I think a big part of it is creating trust, creating comfort with taking on risks. And so 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 kind of mentioned in passing. And you're like, yeah, I'm happy to go with that. And so 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.

54:04Now, if I were the defense attorney or the financial advising industry, I'd say, look, this might not be the best thing for the individuals, but it was better than what they would have done without the financial advisor, because then they would have just been like these behavioral economists I told you about who have all their money in cash. No, they should be in stocks. And if it takes paying 90 basis points per year in 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?

54:38No, I take it to a mechanic. And the mechanic charges me a whole bunch of money. and you can say, oh, that was a ripoff. You fool, you should have just changed the oil yourself and saved a lot of money, but now, like it's actually a good thing that I can get some other person to change my oil for me. That would be kind of the defense I would give or the defense attorney for the financial advising industry. So I think there's that. And then really interesting, you ask people about their financial advisors and 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.

55:18Actually, 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. And portfolio performance is like way, way down on the list of things that they value. And so it does suggest that these folks are doing something different than what we might of thought they are really doing. You've got another really interesting empirical paper on people not taking advantage of employer matching in their 401k plans. I'm going to skip asking about that, but I think your finding is that they're making a mistake by not contributing.

55:56In 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 behavior. 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?

56:34Maybe they choose cheaper funds, but not all the way. So 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 favorable 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.

57:16And that's comparing you versus somebody else who had exactly the same asset allocation from kind of 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 favorable return than you, and you will increase your contribution to 401k more than your coworker would. So that's kind of that earlier thing. But then I'll recommend Mendei, Stefan Nagel, and many others have shown that living through stock market returns that are favorable, cause you to just over your life, invest more in stocks going forward. And 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.

58:01So these personal experience effects are pretty pervasive, even among people that we would 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. And 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.

58:38And 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 their personal portfolios. They even invest in those same funds after they have left the advising industry. You can still look at their portfolios.

59:14They're still true believers. What interventions do you think are most promising for improving the behavior of households? I think it's going to be a combination of things. So there's been a lot of emphasis in policy circles over the last 15, 20 years on automaticity. So then defaulting people into certain kinds of choices, you have to opt out of saving in retirement rather than opting 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.

59:49That's kind of been a big thing, not just in North America, but globally. I think that we need to be appropriately modest about what these sorts of interventions are going to do. So 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 and that we want them to move in. But there are all sorts of margins on which people adjust. So it's like, yeah, we got you to eat the salad for lunch, but that means you pig out at dinner. And I think you see some of that behavior as well in these financial domains where we nudge you to save more in your retirement account.

1:00:27Turns out that maybe you borrow a little bit more or you take a bunch of the money out when you transition jobs. So 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. So there are all these margins of offset that we need to be aware of. Just be modest that we probably are not going to nudge our way to financial salvation. We're going to make things a little better. But honestly, maybe I'll get in trouble someday when I'm in my Senate confirmation hearing or something for saying this. I have gained more sympathy over the years to these forced savings mechanisms like what you have in Singapore or Australia.

1:01:13It'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 off 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 them 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 kind of non-trivial amount of wealth? Almost all in these highly illiquid forms, like housing, like retirement savings accounts.

1:01:54And 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. And 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. And they say, it's a bad idea to be cash poor house rich, but you do see this phenomenon around the world. And I can't remember if there was data in this paper from Canada, but certainly in the US, a lot of people who are living paycheck to paycheck, even though they have significant assets that are in illiquid form, kind of the form of a house or retirement savings plan.

1:02:46And so 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 paycheck to paycheck. They have a lot of money, a lot of assets, actually. But they're running out of money at the end of every month. And one view is that that's actually an optimal choice for them. They're earning such high returns on their illiquid assets that it's worth it for them to be paycheck to paycheck outside of those illiquid assets. Another point of view is, look, these people are just out of control. And they have salted away some money in their house.

1:03:19That's a good thing because it's forcing them to accumulate some assets, but their lives are 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 might've 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.

1:03:51But once you kind of take into account all the other constraints, that you'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. And I think I'm pretty relaxed on a general view. Some people have read some media stories about my views where I'm like, I'm a renter for life. And 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, et cetera, et cetera.

1:04:28Yeah, you should own. I just don't think that there's this enormous financial penalty, if 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. And 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.

1:05:16The fees that are associated with it are pretty high, and there's a big hassle cost. And if you lose your job, for example, and 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. And so just in the state of the world where you could really use that home equity, 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. So for example, your neighborhood could go to pot.

1:05:48So that's not hedging any future housing costs. Just your neighborhood went to pot, your house is worth less. And if you were to move, then you're just kind of out of luck. It depends a lot on where you're going to move to next. So if you're going to move in the same neighborhood, 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 even negatively correlated with your own housing cost, then it's a pretty bad hedge. And 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.

1:06:24So 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's out of your control. That's why you see that, especially over short ownership spells, housing 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.

1:07:00He's been doing some stuff on housing, people who are flipping houses. Are they actually making a profit or not? Quite interesting. thing. 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 this annualized standard deviation of the housing return as a function of holding period? And it turns out the longer you hold the house, the lower the annualized standard deviation is of your financial return. And then he looks into why is that? And the explanation he comes up with is this execution risk.

1:07:35So 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 the situation. Really interesting. I'll have to look at that. In this area of practical finance, of making economics useful for people, kind of 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 to 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.

1:08:19So 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 is here's this thing that's useful for institutional money managers, which is a valuable thing.

1:09:03We'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 kind of 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. So that's a huge preoccupation for individuals. And you see it 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. And so then we leave it to the Susie Ormans and the Dave Ramseys and the Instagram influencers or whatever to give that advice.

1:09:42Hey, 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 has created you to be and to have a relationship with him and to love him, to love your neighbor, to love your family and to serve. And 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.

1:10:19And so 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. And so 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. And 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.

1:10:56And so I'm trying to build my eulogy virtues more so than my resume virtues. We'll see hopefully in a few decades, not imminently, how successful I've been at that. Great answer. James, this 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.